Economics for Business Decisions (English Version)-munotes

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UNIT -I
UNIT -1
BASIC PRINCIPLES IN BUSINESS
ECONOMICS
Unit Structure
1.0 Objectives
1.1 Meaning
1.2 Scope of Business Economics
1.3 Concept of Scarcity
1.4 Concept of Economic Efficiency
1.5 Production Efficiency and Production Possibility Frontier
1.6 Incremental and Marginal Principle
1.7 The Profit Maximization Principle
1.8 Market Economy and Invisible Hand
1.9 Opportunity Cost
1.10 Accounting Profit and Economic Profit
1.11 Summary
1.12 Questions
1.0OBJECTIVES
To understand th e Meaning and scope of Business Economics
To study the Twin principles of scarcity and efficiency
To understand the concepts of Incremental and Marginal principle
To study Profit maximization principle
To understand the concepts of Market economy and invis ible hand
To study the Production possibility frontier
To study the concept of Opportunity cost
To study the difference between Accounting profit and economic
profit
1.1 MEANING
Business or managerial economics involves application of
economic principl es to the problems of the firm or business enterprise
which are productive economic units operating in an economy. Business
economics assumes micro -economic character. As a specialized branch ofmunotes.in

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economics, it adopts and adapts economic models in the proble m solving
and decision making process of a firm. It studies the problems and
principles of individual firms or an industry and helps the business firm in
forecasting and evaluating market trends. It is normative in nature and
therefore it is prescriptive i n character i.e., it is concerned with what firm
should do under the given conditions in which it operates. It determines
the objectives of the enterprise and then develops the means to achieve the
laid down objectives. It deals with future planning, polic y making and
decision making.
Business economics also draws upon macro -economic principles
and theories because though the firm is a micro -economic unit, it operates
in a macro -economic environment. The macro -economic environment
constitutes monetary and fiscal policies, industrial policy, price and
distribution policies, wage policies, trade cycles and the international
economy.
Business economics as a subject became popular in USA when
Joel Dean wrote his book “Managerial Economics” in 1951, with a view
to fill the gap between economic theory and business management. Since
then Business economics as a specialized discipline has advanced a great
deal. Today, economists are not only employed in Universities, Colleges
and financial institution but also a la rge number of business firms
operating all over the world. The Business economist has become an
important agent in the decision -making process of a business enterprise.
The meaning of Business economics will become clear with the study of a
few important definitions.
Spencer and Siegelman, “Managerial economics is the integration of
economic theory with business practice for the purpose of facilitating
decision -making and forward planning by management.”
Evan J. Douglas, “Managerial economics is concerne d with the
application of economic principles and methodologies to the decision
making process within the firm or organization under the conditions of
uncertainty.”
Dominic Salvatore , “Managerial economics refers to the application of
economic theory and the tools of analysis of decision science to examine
how an organization can achieve its aims or objectives most efficiently.”
(Ref. Managerial Economics in a Global Economy, 2003, p.4).
All these definitions have one thing in common i.e., the
involvemen t of economics and business management in the study of
Business economics. Thus Business economics is the synthesis of
economics and business management. It is a process of application of the
principles, techniques and concepts of economics to solve the Bu siness
problem of decision making in a firm or business enterprise. Evan Douglas
refers to the conditions of uncertainty because the macro -economicmunotes.in

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environment is unstable and uncertain. The variables of the macro -
economic environment are beyond the contro l of a firm or business
enterprise. Business economics helps the firm to respond to the changes in
the macro -economic environment and also forecast the futuristic changes
given the existing economic environment, so that the firm or business
enterprise is a ble to adjust to the changes and then develops the means to
achieve the laid down objectives. It deals with future planning, policy
making and decision making. The decision sciences that Dominic
Salvatore is talking about are statistics, mathematics, oper ations research,
econometrics, accounting and the theory of decision making.
Business economics also draws upon macro -economic principles
and theories because though the firm is a micro -economic unit, it operates
in a macro -economic environment. The macro -economic environment
constitutes monetary and fiscal policies, industrial policy, price and
distribution policies, wage policies, trade cycles and the international
economy.
1.2 SCOPE OF BUSINESS ECONOMICS
The scope of business economics includes the fo llowing:
1. Demand Analysis and Forecasting
2. Cost Analysis
3. Market Structure
4. Price determination in different markets
5. Profit analysis
6. Capital budgeting
1.2.1 DEMAND ANALYSIS AND FORECASTING
Demand is defined as “Desire backed by willingness and ability to
pay.” The concept of demand has three aspects, namely; (i) the desire to
buy, (ii) the willingness to pay and (iii) the ability to pay. These three
aspects combined together constitute demand. The absence of any one of
these three aspects will nullify demand . For instance, the consumer may
have the desire to buy but is not willing to pay or the consumer has both
the desire and willingness to pay but do not have the ability to pay or the
consumer has the ability to pay but not the willingness and desire to buy .
All these situations or instances do not constitute demand. India is
believed to be self -sufficient in her food requirements. The go -downs of
Food Corporation of India are overflowing. However food self -sufficiency
in India is true only from the economic or the demand point of view as 14
percent of India’s population is living below the poverty line according to
World Bank figures for the year 2011. If demand for food is generated by
100 percent of the population, India would become a food deficit country
and may have to depend upon food imports to satisfy domestic food
demand. Mere desire to buy and the willingness to pay without the ability
to pay cannot and does not constitute demand.munotes.in

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The demand determinants for a given product are in a constant flux .
They never remain constant over long periods. Prices of substitutes,
complementary goods, income, taste, habit, preferences of the consumers,
population, the macro -economic environment both national and
international, everything undergoes a change over t he long run. These
variables create an environment of risk and uncertainty.
A business firm, although a micro -economic unit, operates in a
macro -economic environment. Demand forecasting is essentially required
to ascertain the viability of its operation s in the market. The economic
viability of a firm not only depends upon the market demand for its
product/s in the present but also in the future.
Futuristic demand projection is required to calculate the breakeven
point of a firm i.e., the operational point when the revenues are equal to
cost. The firm begins to enjoy pure business profits only after breaking
even. Such a breakeven point differs from industry to industry. Industries
with smaller gestations lag will breakeven earlier than industries with
longer gestation lag. While the consumer goods industries have a smaller
or shorter gestation lag, the capital goods industries have a longer
gestation lag. Hence, demand forecasting can vary from a very short
period such as a week, a month or a quarter u p to a period of one year to
longer periods over and above one year to about twenty years. Broadly,
demand forecasting in terms of the time period can be classified into short
term and long term forecasting. However, in a free market economy, any
projectio n beyond a period of five years is likely to go wrong because
firms no longer operate in a protected environment. There is not only
competition from within but also competition from without. This is true in
the case of rapidly globalizing national economie s, where -in the firms
need to be big, bold and beautiful to operate in the international market.
For an international firm, demand forecasting needs to be undertaken on
an international scale and given the scale of operations. Such forecasts are
logically long term forecasts.
1.2.2 COST ANALYSIS
The concept of cost is central to business decision -making. Cost
consciousness contributes to cost minimization or cost optimization which
leads to cost effectiveness and business expansion. A firm which produces
its goods and services at a comparatively lower cost with a qualitative
edge over its competitors will not only survive but also prosper. The
micro -economic effect of cost consciousness will be the prosperity of
individual firms. When cost effective firms in different industries and
sectors of the economy produces its goods and services by minimizing
cost and maximizing quality, the macro -economic effect would be
increase in economic welfare of the largest possible number of people.
The business economi st must be aware of the short run costs
because they are important in deciding price and output of the firm. Themunotes.in

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long run costs are also important. However, their importance lies in
deciding the investment and growth policies of the firm. In the business
context, the importance of cost in managerial decision making can be
explained in terms of price and output decisions, entry barriers, market -
structure and growth policy. It is also important for the government to
understand the cost and cost structure of t he industry because it is the
regulatory and law -making body which governs the industry.
Prices are no doubt determined by costs in all market structures,
be it be market determined prices or administered prices as in the case of
public enterprises. Cos ts determines price and output in both the time
periods i.e. the short run and the long run because the profit maximizing
equilibrium condition (MC = MR) do not change with the change in the
time period. The manager of a monopoly firm can simply add a marg in to
the cost in order to determine the price but the manager of an oligopoly
firm can only compete on the basis of cost. One of the leadership models
in oligopoly is based on low cost known as the low cost price leadership
model.
Costs determine the he ight of entry barriers in imperfect markets.
The lower the cost of production, the greater will be the entry barrier
raised by the firm and the more difficult will it be for a new firm to find
foothold in the industry. Costs also determine the structure of the market.
Large economies of scale can only be reaped by large firms and hence
their cost of production will be lower. Larger the size of the firms, fewer
will be the number operating in an industry and the market form that may
emerge will be the oligop oly market. The direction of growth of a firm is
also determined by cost. A firm facing a ‘U’ shaped average cost curve
will decide to set up new production facilities as part of its expansion
plans in a growing market. In other circumstances such as a sat urated
market, the firm may aim at diversification. The decisions on vertical and
horizontal integration are based on cost considerations. Post liberalization,
the attempts made by larger firms in terms of take -over and mergers both
friendly and hostile is also based on cost considerations. Finally, the
administrative apparatus of the government must be aware of the cost
structure of the various industries in the country to put in place a proper
regulatory mechanism.
In order to make effectiv e business decisions, the business
economist needs to be aware of a number of cost concepts and their
respective uses such as actual and opportunity cost, incremental and sunk
cost, historical and replacement cost etc.
1.2.3 MARKET STRUCTURE
A Market may be defined as any place or process that brings
buyers and sellers together with an objective to enter into a
transaction at an agreed price. The functions of a market economy are
carried out through the market mechanism. Markets are therefor e the verymunotes.in

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basis of an economy. Markets may be found in different forms such as the
organized markets for commodities like oil, sugar, wheat, rice, gold,
copper, iron, rubber and what have you, financial markets for stocks,
shares, currencies of the world and financial instruments of various types,
goods markets consisting of various goods and services which are traded
through the market mechanism, factor markets through which factor inputs
like land, labour, capital and enterprise are traded.
Themarket structures with their important characteristic features are
shown in Table 1.1 below.
In economics market structure is also known as market form . The
word market structure describes the state of a market with respect to
competition. Markets can be distinguished by the number of firms in the
market and the type of product that they sell. Market structure is
determined by a number of factors. The presence or absence of these
factors will determine the nature of t he market. Thus a market with
differentiated products with some entry barriers and large number of
sellers would be known as monopolistically competitive market and one
with the same features but with few sellers would be known as an
Oligopoly market. Idea l markets are full with economic freedoms and
they are the most competitive markets. Such markets are known as
perfectly competitive markets. The competitiveness of the market depends
upon the power of individual firms to influence market prices. The less
power an individual firm has to influence the market in which it sells its
product, the more competitive that market is. The extreme form of
competitive market structure comes into existence when each firm in the
market has zero market power. Market struct ures are therefore either
perfect or imperfect. Between perfect and imperfect competition, the two
ends of market structure, a number of markets will be found. The nature of
these markets will be determined by a combination of factors. These
factors or the determinants of market structure are as follows:
1.Freedom of entry and exit.
2.Nature of the product i.e. whether the product is homogenous or
differentiated?Table 1.1 -Market Structures
Market Structure Seller
Entry
BarriersNumber
of
SellersBuyer
Entry
BarriersNumber
of
Buyers
Perfect
CompetitionNo Many No Many
Monopolistic
CompetitionNo Many No Many
Oligopoly Yes Few No Many
Monopoly Yes One No Many
Duopoly Yes Two No Many
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3.Control over supply and output or the absence of it.
4.Control over price or the absence of control.
5.Barriers to entry and exit.
1.2.4 PRICE DETERMINATION IN DIFFERENT MARKETS
The firms that produce a given product and its close substitutes put
together are known as an industry. The industry demand curve is the
market demand curve for any firm in the industry. When firms decide their
output, they must know as to what quantity of output will be sold at
various prices. Hence, the firms are interested to know their individual
demand curve. The structure of the market in which a firm operates
determines th e relationship between the market demand curve for the
product and the individual demand curve of the firm in a given industry.
Once the individual demand curve is known to the firm, it can easily
determine its price and output policy. The ability of the f irm to decide its
price and output policy depends upon the nature of the market structure in
which the firm is situated. Thus a competitive firm with zero market
power can in no way influence the market price of the product that it
produces. A competitive firm is a price taker and not a price maker. It
simply has to accept the market price and once the market price is known,
a competitive firm can only decide its equilibrium output.
In contrast, the monopoly firm has the maximum market power. Its
demand cu rve is also the industry demand curve. It is therefore free to
either decide its price or its output. However, a monopoly firm cannot
decide both price and output simultaneously. If it decides the output, the
price will be determined by the market demand c urve and alternatively if it
chooses to decide the price, the quantity of output will be determined by
market demand. Between these two extreme forms of market structures,
you may find market forms like monopolistic markets, duopoly and
oligopoly markets. While the monopolistic firms are fairly independent in
determining their price and output policies, the same cannot be said about
duopoly and oligopoly markets because there is a fair amount of inter -
dependence amongst the firms in these markets in determi ning their price
and output policies.
A study of market structures helps us to understand the behavior of
firms operating in different market structures. It helps us to know as to
how price and output in different market structures is determined. The
nature of competition is also determined by the market structure. Price and
non-price competition are the two forms of competition. Price competition
leads to price war and evaporation of super -normal profits under
imperfectly competitive market structures po sitioned between perfect
competition and monopoly. Non -price competition may assume the form
of product differentiation and advertising. Non -price competition helps the
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1.2.5 PROFIT ANALYSIS
The equilibrium condition of any firm under any market is (MC =
MR). It is also the profit maximizing condition. However, the actual
profit made by the firm depends upon, amongst other things, the position
of the cost and revenue curves. Greate r the difference between these
curves, greater will be the profit and vice versa. The profits made by a
firm also depend upon the nature of the market. In a competitive market,
the firm will make only normal profits in the long run. At the extreme
other you have oligopoly wherein the profits made by a firm will depend
upon the nature of oligopoly. In collusive oligopoly, there is market
sharing and the price is determined by the market leader. The firms can
make super normal profits. However, under no n-collusive oligopoly, the
firms will make only normal profits due to competition and price war. A
monopoly firm will always make super normal profits. Firms under
monopolistic competition may make super normal profits in the short run.
Profit maximizat ion is not the sole objective of a firm in globalized
markets. A firm may pursue sales maximization policy and hence take
lower profits so that new markets are accessed. Yet another firm may
pursue utility maximization or staff maximization as the object ive.
1.2.6 CAPITAL BUDGETING
Investment decision making is known as capital budgeting.
Amongst alternative investment avenues, the firm has to decide on the
most profitable investment opportunity. The study of capital budgeting
involves stages such as the search for investment opportunities,
forecasting cash flows expected to flow from each investment opportunity,
computing the cost of capital and identifying the most profitable
investment opportunity. Firms may use various methods to evaluate
investme nt decisions such as the payback period method, the net present
value method or the internal rate of return method.
Check your progress:
1. Explain the meaning of Business economics.
2. Discuss demand and demand analysis in Business economics.
3. Discuss the relevance of concept of cost in business economics.
4. What are the different types of markets?
5. Explain how prices are determine in different markets?
6. What is the profit maximization condition?
7. What do you understand by capital budgeting?
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1.3 CONCEPT OF SCARCITY
The productive resources like land, labor, capital and enterprise
available for the human society are scarce or limited. Land refers to the
fertility of the soil, climate, forests and the mineral deposits, water
resources etc. Labor is the human resource that is used to produce goods
and services. Labor involves both physical and mental labor. Capital
refers to the machinery, factories, equipment, tools, inventories, irrigation
and trans portation and communication facilities. Capital is produced
means of production and hence it is used to produce other goods and
services. Money is only a medium of exchange and as Alfred Marshall
said, money alone cannot produce a single blade of grass. However,
money in the form financial capital is a productive resource. Finally, the
enterprise or the entrepreneur is the most important productive or
economic resource because the entrepreneur is the pivot around which all
economic activities revolve. T he entrepreneur is the decision maker in the
economy. The big economic questions: what to produce, how to produce,
how much to produce, for whom to produce, when and where to produce
etc are answered by the entrepreneurs. Without entrepreneurs, there wil l
be no surplus and without surplus there will be no trade.
Scarcity of resources is the driving force behind all human
endeavors. If resources were unlimited, human beings would not exert
and would have lived and died like sloths. While the resources a re scarce,
human wants are unlimited. However, these unlimited wants are gradable
and can be postponed. Resources, although scarce, have alternative uses
i.e. they can be put to different uses. Limited resources and unlimited
human wants are reconciled through alternative use of resources and
gradation of human wants. Choosing between military goods and food,
one can allocate more resources to food and produce more food or allocate
more resources to military goods and produce more military goods.
Choic e involves trade -off. If you chose to produce more military goods,
you will have to sacrifice some food and vice versa. Trade -off is the
result of scarcity of resources. Wants can be graded on the basis of
importance. More important wants will be satis fied first and less
important wants will be satisfied later.
Resources are cumulative. Overtime, the resource pool available
to the human society increases and hence the production capacity also
increases. Innovations and inventions leads to higher prod uctivity and
higher output leading to greater satisfaction of human wants. However,
human wants are always greater than what the available resources can
satisfy. Hence, resources will always remain scarce.
1.4 CONCEPT OF ECONOMIC EFFICIENCY
A free mark et economy is one in which the four economic
functions of production, distribution, consumption and exchange aremunotes.in

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carried out according to the forces of market demand and market
supply. The free market forces determine both product and factor prices
and re sults in the efficient allocation of resources. A free market economy
can operate only in a democratic country with capitalist economic system.
The economic system is the mirror image of the political system. Markets
cannot be free if there is no democr acy and markets cannot be efficient if
they are not free.
Economic efficiency means that the economy’s resources are used
effectively to satisfy the maximum possible wants of the people. An
economy must achieve both production and allocation efficiency t or e a l i z e
economic efficiency. Production efficiency occurs when an economy
cannot produce more of one good without producing less of another good.
It means that the economy is operating on the production possibility curve
and goods and services are prod uced at the lowest possible cost. When
goods and services are produced according to the tastes and
preferences of the people, allocation efficiency is achieved. When both
production and allocation efficiencies are achieved, economic efficiency is
achiev ed. Economic efficiency is a situation in which optimum allocation
of resources takes place. In the actual world, economic efficiency is
scarcely achieved because of the uneconomic use of resources and the
retrograde economic policies adopted by countrie s.
1.5 PRODUCTION EFFICIENCY AND PRODUCTION
POSSIBILITY FRONTIER
The achievement of production efficiency is explained in Fig.1.1 below.
Fig. 1.1 Production Efficiencymunotes.in

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Point M in Fig. 1.1 shows unemployment or under -utilization of
productive resources in the economy. A movement from point M to point
N shows that the economy is fully utilizing its productive resources and
full employment is achieved. Production efficiency is achieved when the
economy operates on the production possibility frontier. Any point on the
PPC would show the achievement of production efficiency.
1.5.1 Production Efficiency and Average Cost Curves
Production efficiency can also be shown by using firm’s cost
curves. This is shown in Fig .1.2 which consists of three average cost
curves. The least cost optimum output will be produced only on AC 3at
its lowest point or minimum point because it is the lowest average cost
curve in the figure. Such a lowest point is point E on AC 3and is kno wn as
the point of technical efficiency.
Fig.1.2: Production Efficiency (Point of Technical Efficiency).
1.5.2 Production Efficiency and Perfect Competition
Production efficiency can be achieved only under the conditions of
perfect competition. Firms must produce at the lowest possible cost to
maximize profits. Firms who are not able to achieve production efficiency
will have to exit the market because other firms would be operating on the
lowest point of the lowest average cost curve. Achiev ement of production
efficiency in perfect competition is shown in Fig.1.3.munotes.in

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Fig.1.3 Production Efficiency and Perfect Competition
Fig.1.3 shows the long run equilibrium of a firm under perfect
competition. Point E is the point of least cost maximum o utput. The
equilibrium condition of the firm is MC = MR. At point E, the MC curve
intersects the AC curve at its minimum point and the condition of
technical efficiency is achieved. Point E is also the point where the MC
curve intersects the MR curve fr om below and the AC curve is tangent to
the AR = MR curve at point E. In this manner, under the conditions of
perfect competition, the condition of Grand Equilibrium is achieved. Thus
with production efficiency, economic welfare is also maximized under t he
conditions of perfect competition.
1.5.3 Allocation Efficiency
When goods and services are produced at the least possible cost
and also according to the tastes and preferences of the consumers,
allocation efficiency is achieved. Such a combination of goods and
services should yield the greatest possible satisfaction to the consumers.
Technically, allocation efficiency will be achieved when the price of a
product is equal to the marginal cost of the product. When price is
equal to MC, it represents t he correct economic cost of producing the last
unit of the product. Such a situation is also shown in Fig.1.3 where the
condition of Grand Equilibrium is achieved by the firm under perfect
competition in the long run. A numerical explanation of the conce pt of
allocation efficiency is given in Table 1.2
The condition of equilibrium of a firm is MC = MR. The equilibrium
condition is achieved when four units of output is produced because at this
level of output, the price is equal to marginal cost. Since price or average
revenue is also equal to marginal revenue under the conditions of perfect
competition, it can be said allocation efficiency is achieved when Grand
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Check your progre ss:
1. What do you understand by scarcity in business economics?
2. What is the meaning of economic efficiency?
3. What is the role of Production Possibility Frontier in production
efficiency?
4. What is the meaning of allocative efficiency?
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1.6 INCREMENTAL AND MARGINAL PRINCIPLE
Economics as a science assume that people are rational and that
individuals take decisions on the basis of valid reasons. The individual
maximizes utility or satisfaction from the consumpti on of one or more
goods. How many units of the good should be consumed or purchased by
the individual at the given price? Every consumer or buyer has to face this
question.
According to the law of diminishing marginal utility, the consumer
will take t he decision at the margin. For example, let us assume that the
price of one chocolate is Rs. 10 and the first unit of the chocolate gives 15
utils of satisfaction. Since the satisfaction derived from the first unit of
chocolate is greater than the price paid, the consumer will try to maximize
his total satisfaction by buying one more unit of chocolate. The second
unit of chocolate gives him 12 utils of satisfaction. The marginal utility of
the second unit continues to be greater than the price paid. He nce, the
consumer purchases the third unit of chocolate and receives only 10 utils
of satisfaction. Now when the price paid by the consumer and the utility
derived from the third marginal unit is equal, the consumer is in
equilibrium and also gets maximum total satisfaction of 37 utils. From the
following utility schedule, you will find that the fourth unit of chocolate
gives only eight utils of satisfaction. Our consumer will not buy the fourthTable 1.2
Quantity
(Q)Price
(INR)Total
Utility
(TU)Marginal Utility
(MU n=T U n–TUn–
1)Price &
MU
1 10 15 15–0 = 15 MU > P
2 10 27 27–15 = 12 MU > P
3 10 37 37–27 = 10 MU = P
4 10 45 45–37 = 8 MU 5 10 50 50–45 = 5 MU < P
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unit of chocolate because the marginal utility is less than the price paid (8
–10 = -2). In this example, the consumer’s decision to buy three units of
chocolates has been taken on the margin.
Individuals make incremental decisions i.e. one more unit of
chocolate at a time. Economists use the term marginal chan ges to describe
incremental changes in the plan of buying chocolates. Margin means last
or the edge. Marginal changes are therefore changes at the end or at the
edge of what one does. Rational individuals make decisions by comparing
marginal benefits an d marginal costs. When you have your lunch or
dinner, whether to have one more chapatti or not is the question that you
have in your mind towards the end of your lunch or dinner. The question
is therefore at the margin or at the end. We normally take de cisions at the
margin. Whether to buy one more unit of a trouser or a shirt, whether to
drink one more glass of lassi, eat one more gulab -jamun etc are all
questions at the margin and the decisions taken are also at the margin.
The firm or the producer a lso decides at the margin. The
equilibrium of a firm in all markets is determined at the point of equality
between marginal cost and marginal revenue. The total quantity of output
produced by a firm is also taken at the margin. The producer will not
produce additional units beyond the point of equality because that will
lead to marginal loss (MC > MR). A rational producer or a consumer will
produce or consume one more unit only if the marginal benefit is greater
than the marginal cost and stop his actio n of production or consumption
when the marginal benefit is equal to the marginal cost.
1.7 THE PROFIT MAXIMIZATION PRINCIPLE
Profits are maximized when the marginal cost of an additional unit of
output is equal to the marginal revenue obtained by sellin g one additional
unit of sale (MC = MR). The equality between marginal cost and
marginal revenue is the profit maximizing condition in all types of
markets. The principle of profit maximization is explained with the help
of a cost and revenue schedule of the firm ‘Ramji Dairy Farm’.munotes.in

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Table 1. 3–Profit Maximization (in INR)
Quantity
(Liters)Total
RevenueTotal
CostProfit Marginal
RevenueMarginal
CostChange in
Profit
(Q) (TR) (TC) (TR
–
TC)(MR =
TRn-
TRn–1)(MC =
TCn–
TCn–1)(MR –
MC)
0 0 20 -20 - - -
1 40 30 10 40 10 10
2 80 48 32 40 18 22
3 120 72 48 40 24 16
4 160 110 50 40 38 02
5 200 150 50 40 40 0
6 240 200 40 40 50 -10
In Table 1. 3, column one, the number of liters of milk that the dairy farm
will suppl y is shown. The second column shows total revenue that Ramji
Dairy Farm will receive at various levels of output. The third column
shows total cost which includes fixed cost. The fixed cost is Rs.20 and the
variable cost will depend upon the units of ou tput produced. The fourth
column shows profit which is computed by subtracting total cost from
total revenue (TR -TC). When the Dairy produces one liter of milk, it
makes a profit of Rs.10. As the production of milk goes up, the profit also
goes up. I n order to maximize profits, the Dairy Firm will compare
marginal revenue from each additional liter of milk with that of the
marginal cost of producing one more liter of milk. The firm will continue
to produce more milk as long as marginal revenue is gre ater than marginal
cost. The MR and MC are computed in the fifth and sixth columns of the
table. Since the price per liter of milk is held constant under the
conditions of perfect competition, the marginal revenue remains constant.
The marginal cost is obtained from the total cost column. When one liter
of milk is produced, the total cost is Rs.30 (Rs. 20 + Rs. 10) and the
marginal cost is Rs.10 (Rs.30 –Rs.20). When additional liters of milk are
produced, the marginal cost goes on rising. When the fi fth liter of milk is
produced, both the marginal cost and marginal are equal i.e. Rs.40 and the
change in profit is zero as shown in column seven. When the sixth liter of
milk is produced, the marginal cost is Rs.50 and a result the profit falls by
Rs.10. Hence Ramji Dairy Farm will not produce the sixth liter of milk.
Profit is maximized when the fifth liter of milk is produced because, at this
level of output, the marginal cost is equal to marginal revenue and the total
profit made by the farm is maxim ized. Ramji Dairy Farm is rational in its
decision making and therefore decides its profit maximizing output of five
liters of milk at the margin. The marginal principle helps Ramji Dairy
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1.8 MARKET ECONO MY AND INVISIBLE HAND
In a market economy, the economic decisions are taken by free
consumers and producers. The consumers are known to be sovereign in a
market economy. The choices and preferences of the consumers are taken
into consideration by the pr oducers or the firms in their decision making.
What to produce? –is the question before the producer. What to
consume? –is the question before the consumer. The choices made by the
consumer translate into demand for goods and services and producers
make their decisions on the basis of demand for various goods and
services. Thus the questions: What to consume and how much to consume
reveal the choices, preferences and the quantities of various goods and
services that will be consumed by the consumers. The firms’ decision on
the question of how to produce is answered by the factor mix that the firm
will have to employ in producing goods and services. Land, labor, capital
and enterprise are the factor inputs. A given combination of these factors
will b e determined by factor prices i.e. rent, wages, interest and profits.
Both factor prices and product prices are determined by the market forces
of demand and supply. Price is the pivot around which the market
economy revolves.
The price mechanism or the invisible hand helps in optimizing
production and consumption. Only those goods and services are produced
for whom demand has been registered. The markets register the choice
and preferences of the people and accordingly goods and services are
produced. The producers allocate their resources to their most profitable
use in order to maximize profits. Consumers allocate their income to the
consumption of various goods and services with the objective to maximum
consumption or satisfaction. Profit maximiz ation by the firms is
reconciled by maximization of satisfaction by the consumers. Price
mechanism is the signaling device in the market that leads to desirable
outcomes. Market prices reflect the value of a commodity to the society
and the cost to the s ociety of producing the commodity. The price
mechanism leads to maximum social welfare and also profit
maximization.
1.9 OPPORTUNITY COST
Opportunity cost is the cost of next best opportunity lost. Every
economic activity has an opportunity cost. Th e opportunity cost can be
explained in terms of the Production Possibility Curve. As we move from
left to right on the PPC, we produce more of commodity X and in order to
produce more of commodity X, we sacrifice some units of commodity Y.
The extent of sacrifice made of units of commodity Y to produce one
more unit of commodity X is the opportunity cost of producing one more
unit of Commodity Y. In the ordinary course of life, the concept may be
explained by taking an example of a student who attends co llege. The
opportunity cost of attending college can be explained in terms of the timemunotes.in

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that he or she could productively utilize by taking up employment and
earn some money.
1.9.1 Opportunity Cost and the PPC
The resources available in an economy are limited and human
wants are unlimited. Hence the problem of choice is created. The
problem of choice is solved because wants are gradable. Wants can be
graded into different categories on the basis of urgency or desirability.
Thus most urgent and most desirable wants will be satisfied first and lesser
order wants will be satisfied later. While the wants are classified and
decided to be satisfied, individuals are actually making a choice between
more important and less important wants. The true cost o f any choice we
make between alternatives is expressed by economists through the idea of
opportunity cost. Opportunity cost is the cost of the next best alternative
lost. The PPC also explains the incidence of opportunity cost while a
movement is being m ade on it. Assuming that a society decides to
produce two goods namely; motor cars and food with its available
resources, the PPC will tell us as to how much of each good will be
produced given a choice on the PPC. If we measure Motor Cars on the Y -
axis and Food on the X -axis, a point chosen on the PPC intercept on the
Y-axis would reveal that the society is allocating all its resources for the
production of Motor Cars and no food is produced, thereby sacrificing
food in its entirety. The PPC therefore s hows opportunity cost of
manufacturing motor cars in terms of food. Assuming that the society has
chosen point N on the PPC, OC 1Motor Cars and OF 1food will be
produced. Thus in order to produce OF 1food the society has to sacrifice
CC 1of motor cars. C C1motor cars are therefore the opportunity cost of
producing OF 1food.
Figure 1.4 -Link between PPC and Opportunity Cost.munotes.in

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1.10 ACCOUNTING PROFIT AND ECONOMIC PROFIT
Accounting profit or resid ual profit is obtained by subtracting cost
and expenses incurred from the revenue realized. In order to determine
profit, the accountant subtracts the explicit or actual costs from the
revenue. Accountants take retrospective view of the firm’s financial
statements and evaluate the trends in the performance of the firm.
Accounting cost includes allowance for depreciation of capital equipment.
The depreciation rates are determined by the tax authorities of the country.
The accountant will not consider th e opportunity cost of the sole
proprietor or partner (imputed salary), the interest cost of the capital
employed by the sole proprietor or the partner (imputed interest) and the
rental cost of the land and building owned by the sole proprietor or the
partn er. The family members of the sole proprietor may also lend their
labor in running the firm. Imputed salary for the labor provided by family
member will not considered by the accountant. Thus the accountant’s
view of profit is a very narrow view.
The b usiness economist takes a prospective view of the
profitability of the firm. The economist is concerned with the optimal use
of resources so that the average cost is minimized. The economist takes
into consideration both implicit (opportunity cost) and e xplicit (actual)
costs. Economic profit is the difference between accounting profit and
imputed costs i.e. when imputed costs are subtracted from accounting
profit, economic profit is obtained. Economic profit is more important for
the business economist because it shows the true profitability of the
enterprise. An enterprise making accounting profits may be making
economic losses. Firms making economic losses cannot sustain in the
long run and may have to exit the industry. The imputed costs include
cost of entrepreneurial services in the case of sole proprietorship or a
partnership firm, rent for self -owned land and building employed in the
business and interest on self -owned capital.
Illustration.
Consider the case of M/s Mamta Stationery Stores. T he owner has
invested capital worth Rs.10 million. The yearly sales revenue of the store
is Rs. 15 million. Making allowances for the expenses made by the Store,
the accounting profit is shown in Table 1. 4below.
Table 1. 4Accounting Profit of M/s Mamt a Stationery Stores (in Rs.
millions)
1. Sales 15,000,000
2. Cost of Stationery sold 10,000,000
3. Salaries 2,000,000
4. Depreciation (10%) 1,000,000 13,000,000
5. Accounting Profit 2,000,000munotes.in

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Let us now look at the economic profit made by the Store in Table
1.5. In the statement of economic profit, the opportunity cost of the owner
of the store and the interest cost of the capital invested by the owner is
taken into consideration. You will now find that the economic profit made
by the firm i s negative i.e. the store has actually incurred losses to the
order of Rs. 0.7 million.
1.11 SUMMARY
1.Business economics is the synthesis of economics and bu siness
management. It is a process of application of the principles, techniques
and concepts of economics to solve the Business problem of decision
making in a firm or business enterprise.
2. The scope of business economics includes the following: Demand
Analysis and Forecasting, Cost Analysis, Market Structure, Price
determination in different markets, Profit analysis, Capital budgeting.
3. Economic efficiency means that the economy’s resources are used
effectively to satisfy the maximum possible wants of the people.
When both production and allocation efficiencies are achieved,
economic efficiency is achieved. Economic efficiency is a situation in
which optimum allocation of resources takes place. In the actual
world, economic efficiency is scarcely ach ieved because of the
uneconomic use of resources and the retrograde economic policies
adopted by countries.
4. Production efficiency is achieved when the economy operates on the
production possibility frontier. Any point on the PPC would show the
achiev ement of production efficiency.
5. Technically, allocation efficiency will be achieved when the price of a
product is equal to the marginal cost of the product.Table 1. 5Economic Profit of M/s Mamta Stationery Stores (in Rs.
Millions)
1.Sales 15,000,000
2.Cost of Stationery sold 10,000,000
3.Salaries 2,000,000
4.Depreciation (10%) 1,000,000
5.Opportunity cost of the owner (salary) 1,200,000
6.Opportunity cost of capital (15%) 1,500,000 15,700,000
5.Economic Profit -7,000,00
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6. The equilibrium of a firm in all markets is determined at the point of
equality between m arginal cost and marginal revenue. The total
quantity of output produced by a firm is also taken at the margin. The
producer will not produce additional units beyond the point of equality
because that will lead to marginal loss (MC > MR). A rational
producer or a consumer will produce or consume one more unit only if
the marginal benefit is greater than the marginal cost and stop his
action of production or consumption when the marginal benefit is
equal to the marginal cost.
7. Profits are maximized whe n the marginal cost of an additional unit of
output is equal to the marginal revenue obtained by selling one
additional unit of sale (MC = MR). The equality between marginal
cost and marginal revenue is the profit maximizing condition in all
types of mark ets.
8. The price mechanism or the invisible hand helps in optimizing
production and consumption. Only those goods and services are
produced for whom demand has been registered. The markets register
the choice and preferences of the people and accordingl y goods and
services are produced. The producers allocate their resources to their
most profitable use in order to maximize profits. Consumers allocate
their income to the consumption of various goods and services with
the objective to maximum consumption or satisfaction. The price
mechanism leads to maximum social welfare and also profit
maximization.
9. Opportunity cost is the cost of next best opportunity lost. The
opportunity cost can be explained in terms of the Production
Possibility Curve.
10. Ac counting profit or residual profit is obtained by subtracting cost and
expenses incurred from the revenue realized. In order to determine
profit, the accountant subtracts the explicit or actual costs from the
revenue.
11. Economic profit is the differen ce between accounting profit and
imputed costs i.e. when imputed costs are subtracted from accounting
profit, economic profit is obtained. Economic profit is more important
for the business economist because it shows the true profitability of the
enterpri se.
1.12 QUESTIONS
(1)Explain the meaning and scope of Business economics.
(2)Define and explain the meaning of Business Economics.
(3)The market structure consists of different market forms. Explain.munotes.in

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(4)Explain the principle of scarcity.
(5)Explain the concept of econ omic efficiency.
(6)Explain the Incremental and Marginal principles.
(7)How does the consumer apply the principal of margin to achieve
equilibrium?
(8)Explain the Profit maximization principle.
(9)Explain the role of invisible hand in a market economy.
(10)Explain the con cepts of Market economy and invisible hand.
(11)Explain the concept of Production possibility frontier.
(12)Explain the concept of Opportunity cost and its link with PPF.
(13)Explain the concepts of Accounting profit and economic profit.

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UNIT -1A
MARKET FAILURE AND THE
ECONOMIC ROLE OF THE
GOVERNMENT
Unit Structure
1A.0 Objectives
1A.1 Market Failure and Externalities
1A.2 The Problem o f Externalities
1A.3 The Problem of Merit a nd Demerit Goods (Information Failures)
1A.4 The Problem o f Public Goods
1A.5 Summary
1A.6 Question s
1A.0 OBJECTIVES
To understand the concept of Market failure
To study the concept of Externality
To study Public goods and economic role of Government
1A.1 MARKET FAILURE AND EXTERNALITIES
A market economy is o ne in which all goods and services are
voluntarily exchanged for money at market prices. A market economy
without government intervention maximizes output and therefore
maximizes economic welfare of the society. However, market mechanism
does not always lead to efficient allocation of resources. Economic
efficiency cannot always be achieved through market mechanism.
The term market failure describes the failure of the market
economy to achieve an efficient allocation of resources. Prices must
properly reflect the costs and benefits of production and consumption i.e.
prices must include all the positive and negative externalities that are
associated with production and consumption. However, in case of merit
and demerit goods and in case of public goods , the price mechanism fails
to register externalities correctly and hence State intervention in the
market economy is warranted. If we assume that prices accurately reflect
costs and benefits, decisions made by both producers and consumers will
lead to an efficient allocation of resources and maximization of economic
welfare or economic efficiency. Economic efficiency can only be
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Market is said to be failing when the market forces lead to mal -
alloc ation of scarce resources and fails to maximize economic welfare.
The invisible hand of the market has some imperfections. These
imperfections lead to market failure. The market mechanism fails when it
leads to the following:
1.Overproduction of goods hav ing negative externalities and
underproduction of goods having positive externalities.
2.Under production of merit goods and overproduction of demerit goods.
3.Fails to provide public goods.
4.Creates monopolies.
5.Creates income inequalities.
6.Leads to Imperfect I nformation.
1A.2 THE PROBLEM OF EXTERNALITIES
An externality is said to arise if a third party is affected by the
decisions and actions of others or when there is a divergence between
social cost and social benefits, private costs and private benefits. For
example, the social costs of private motorists can be explained in terms of
road congestion, environmental pollution and possible car accidents. If
the private motorists do not pay for these social costs, their private
benefits will be higher than the ir private costs. In this case, the private
motorists would be generating external costs or negative externalities.
The market will fail to internalize the external costs and hence there will
be overproduction of private motor cars. Hence government int ervention
would be necessary to control negative externalities and to internalize
external costs. Similarly, certain goods and activities may generate
positive externalities. The social and private benefits of vaccination
against diseases such as polio, tuberculosis etc will be much greater than
the social and private costs. The market, however, will fail to optimize the
production of vaccines so that the entire population is vaccinated. The
market will under produce vaccines and a large number of peopl e who
cannot afford to pay market prices for the vaccines will have to suffer
from ill -health. The social cost of such ill -health will be much greater than
the private cost of administering vaccines. Government intervention will
be required to subsidize t he production of vaccines or to have free
distribution of vaccines so that social benefits are maximized.
Over production caused by negative externality is shown in Fig.
1A.1 below.munotes.in

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Fig.1A.1: Over production caused by a negative externality.
Fig.1A.2: Under production caused by a positive externality.
The market fails to internalize negative externalities and hence the
market price will be lower at P 1where the supply curve S 1showing
private costs will be equal to demand and Q 1output of motor cars will be
produced. If the supply curve takes into account social costs, the total cost
(private costs + social costs) will rise and it will shift to the left and a
higher price P 2with a lower output Q 2will be determined. Failure to
internali ze social costs leads to mal -allocation of resources and over -
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Similarly, Fig. 1A.2 shows under -production caused by a positive
externality. In case of positive externality, the product will be under
produced because only private benefits will be taken into account and the
market demand will be shown by demand curve D 1. Accordingly, at price
P1, the quantity demand and supplied will be Q 1. If social benefits are
recognized, then the demand curve wil l shift to the right and will be
represented by D 2. The price will go up to P 2and the quantity demanded
and supplied will be Q 2. However, in the absence of government
intervention, at P 1price only Q 1quantity will be demanded and supplied.
The market therefore fails to optimize the production of goods having
positive externalities.
1A.3 THE PROBLEM OF MERIT AND DEMERIT
GOODS (INFORMATION FAILURES)
Market fails in both the cases of merit and demerit goods. A merit
good has positive externalities. F or example, education, vaccination etc
are merit goods because others who do not consume these goods are also
indirectly benefited. A demerit good has negative externalities. For
instance, cigarettes and liquor are demerit goods because others who do
not consume these goods are adversely affected. In addition to
externalities, merit and demerit goods are associated with information
failures. The over -consumption of a demerit good and the under -
consumption of a merit good are caused due to the lack of re levant
information with the consumer.
In the context of information failure, a merit good may be defined
as a good that is better for a person than the person who may consume the
good realizes. Education and health would be good examples of merit
goods. While, a demerit good may be defined as a good that is worse for a
person than the person who may consume the good realizes. Cigarettes
and liquor would be good examples of demerit goods. In case of
externalities alone, the benefit or loss is to others whereas in case of merit
and demerit goods, the benefits and losses are to the individual who
consume these goods in addition to others who do not consume.
Since the allocation of resources to the production of merit and
demerit goods will not optimal as a result of information failure, the
market is said to be failing in producing the right quantity of these goods.
Thus merit goods will be under -produced and demerit goods will be over -
produced. Inadequate resources will be allocated to the production of
merit goods. Less than optimum demand for merit goods will be
registered due to the lack of adequate information. This is shown in
Fig.2.3. The correct level of demand for a merit good will is represented
by the demand curve D 1if the consumers have sufficient information
about the merit of the product. And the equilibrium price and quantity
demanded will be P 1and Q 1. However, since the consumers fail to realize
the value of the product, a lesser quantity Q2 is demanded at a lower pricemunotes.in

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P2. Lower equilibrium price P 2and quantity demanded Q 2is below the
optimum level and therefore the market has failed.
Fig.1A .4 shows the problem of a demerit good. In this case, the
correct demand should be Q 1and the price P 1. Since the consumers over -
value th e demerit good, a higher demand is registered and therefore a
higher equilibrium price P 2and quantity Q 2is determined. More than
optimum quantity of resources are allocated to the production of demerit
good and therefore the market has failed. Thus in the case of merit and
demerit goods, the market mechanism fails to optimally allocate resources
due to information failures.
Fig.1A.3: Under production of a merit good by the market.
Fig.1A.4: Over -production of a demerit good by the market.munotes.in

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Check your progress:
1. Explain the term market economy.
2. What do you understand by market failure?
3. When externality is said to arise?
4. Distinguish between merit and demerit goods.
____________________________________________________________
________ ____________________________________________________
____________________________________________________________
____________________________________________________________
____________________________________________________________
1A.4 THE PROBLEM OF PU BLIC GOODS.
According to Paul Samuelson and William Nordhaus, “Public
goods are those goods whose benefits are indivisibly spread among the
entire community, whether or not people desire to purchase it”. For
example, the police machinery extends equal pro tection to all the members
of the society whether or not people desire to make use of the machinery.
Similarly, defense services, roadways, the judicial system etc are examples
of public goods. Public goods have two important characteristics. They
are n on-rival in consumption and they are non -excludable.
A good is non -rival in consumption when more than one person
can consume the same thing without reducing the consumption of any
other person. Public goods like defense, police machinery, roads, judi cial
system etc are all non -rival in consumption because people can consume
these services to the extent of their needs without reducing the
consumption of others. A good is non -excludable when people cannot be
prevented from enjoying its benefits. For e xample, a public garden, public
health, public education etc. These goods and services are available to all
even if no payment is made.
In contrast to public goods, private goods are rival in consumption.
For example, if one person is working on a perso nal computer, the other
person cannot use it at the same time without reducing the consumption of
the first person. There is a trade -off involved in private goods. Similarly,
if one person is drinking a can of beer, the other person cannot drink beer
from the same can. Thus private goods are divisible in consumption and
somebody has to pay for it. Private goods are also excludable. For
instance, a person will be admitted into a movie theatre only if he has a
valid ticket. A private good is therefore r ival or divisible in consumption
and is also excludable.
The problem caused by public goods is that the market will fail to
provide public goods due to the problem of free riders. The market will
therefore not allocate resources for the production of pub lic goods
although public goods are highly desirable from the society’s point of
view. Due to the problem of free riding, the market fails to register the
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1. THE PROBLEM OF MONOPOLIES AND DEADWEIGHT LOSS
A monopoly market is domi nated by a single firm. A monopoly
market is inefficient and fails to allocate resources in an optimum manner.
A comparison of price and equilibrium output of a monopoly and a
perfectly competitive firm will clarify market failure caused by a
monopoly fi rm. This is shown in Fig. 1A.5. In a competitive market, the
equilibrium price and quantity demanded is determined at the point of
intersection between the market demand and supply curves. The average
revenue curve AR is the industry demand curve the mar ginal cost curve is
the industry supply curve under perfect competition. Thus the equilibrium
quantity demanded and supplied is Q 1and the price is P 1. In a monopoly
market, the monopoly firm can determine either the price or the quantity.
If he decide s the price, the quantity of output will be determined by market
demand and if decides the quantity of output, the price will be determined
by market demand. The monopoly firm will aim at maximizing profits
and therefore determine equilibrium output at th e point of equality
between marginal cost and marginal revenue (MC = MR).
Accordingly, the monopoly market will produce a lesser output Q 2
and charge a higher price P 2than a competitive market. Since the price set
by the monopoly firm is higher than t he marginal cost, there is no
allocation efficiency. Since optimum output is not produced and cost of
production is not minimized due to the absence of threats, there is no
productive efficiency. Further, the equilibrium of a monopoly firm is
determined to the left of the minimum point of the average cost curve.
Hence there is no technical efficiency. Thus under the conditions of
monopoly equilibrium, economic efficiency cannot be achieved.
Fig.1A.5: A comparison of monopoly and a competitive mark et.
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Monopoly market and the problem of market failure can also be
explained with the economic concept of deadweight loss. Deadweight
loss refers to the loss of economic welfare caused by market imperfections
such as a monopoly market. Th e loss of both consumer and producer
surplus is known as Deadweight loss. This is shown in Fig. 1A.5. The
competitive price is shown as P 1and output as Q 1. This represents
optimum production and consumption. However, the monopoly price is
P2and quanti ty produced is Q 2. There is over -pricing, under -production
and under -consumption in a monopoly market. The shaded triangle in the
figure shows the loss of economic welfare or the existence of deadweight
loss.
Deadweight loss may emerge when the governme nt imposes an
indirect tax on a product. This is shown in Fig 1A.6. The initial
equilibrium point is determined at the intersection of the market demand
supply curves and the equilibrium price and quantity demanded is P 1and
Q1. After the tax is imposed by the government, the supply curve shifts to
the left because the imposition of a tax is equal to increase in the cost of
production. As a result, a higher price P 2is determined and a lower
quantity Q 2is demanded and supplied. Desirable production and
consumption is discouraged because of the higher price. The resulting
loss of economic welfare is shown by the shaded triangle. It shows the
amount of deadweight loss due to the imposition of tax.
Fig. 1A.6: Imposition of indirect tax and the emerg ence of
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2. THE PROBLEM OF INCOME INEQUALITIES
Market economies tend to generate wide income inequalities.
There is a problem of plenty amidst penury. For instance, even after six
decades of planned economic development and growth, India continues to
have about 26 per cent of its population living below the international
poverty line with the top twenty per cent of the population having a share
of 46 per cent in the national income and the bottom 20 per cent with only
eight per cent share in the national income. Wide income inequalities may
lead to a range of social and economic problems.
3. THE PROBLEM OF IMPECTFECT INFORMATION
Imperfect information leads to shortages and surpluses in the
economy. For instance, theoretically, in a fre e market economy,
unemployment should not occur because wages would adjust to absorb the
surplus labor. However in reality, wages may not adjust downwards to
absorb the surplus labor. Further, there may be a number of factors that
may prevent labor from m oving from one occupation to another i.e. to say
that labor is not perfectly mobile between uses or occupations and
between regions.
4. STATE INTERVENTION IN THE MARKET ECONOMY
Governments intervene in the market because the market fails in
providing pub lic goods, it over -produces demerit goods and under -
produces merit goods. Government intervention in the market helps to
correct market failures and achieve an equitable distribution of resources
in the economy.
Government policy and methods of intervent ion can be grouped
under four broad headings. They are regulation, financial intervention,
production and transfer payments. The method chosen will depend on
whether the reason for intervention is concerned with market failure or
with the desire to achie ve equity.
5. REGULATION
The government uses many methods of regulation as a means of
controlling a market. Legal and other methods are used to control the
quality and quantity of goods and services that are produced and
consumed. For example, the gove rnment may regulate the sale of certain
drugs by making them only available on prescription from a qualified
doctor. Hygiene laws set standards for the production of foods. There may
be controls on shop opening hours or the setting of a minimum age at
which a person can buy certain products such as alcohol, cigarettes and
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6. FINANCIAL INTERVENTION
Financial instruments such as taxes and subsidies are also used by
the government to influence production, prices of commodities, incomes
orthe distribution of wealth in an economy. Price subsidies may vary.
They might in the form of partial subsidy in the case of public transport or
total as in the case of free eye tests for children in full time education. Tax
instruments may also vary. For example, vehicle excise duty is paid once
every six months or year unless the vehicle is more than 25 years old. The
same amount is paid whether the car is used daily or only once a month.
In addition, vehicle users pay a tax on petrol. In this cas e, the amount of
tax paid rises with the number of miles driven. The first type of tax may
deter ownership of a vehicle while the second deters use of the vehicle.
Governments also provide finance that is needed to produce a good or
service. For example , the government could finance education but all
schools, colleges and universities could be privately owned and run.
Health care may be provided free but the drugs used in prevention and
cure of illness could be privately produced.
Use of Indirect Taxe s and Subsidies by the Government to Deal
with the Problem of Externalities.
The use of taxes and subsidies to deal with the problems of market
failures caused by externalities is a case of financial intervention. A tax is
imposed on the firm which creat es externality. Once tax is imposed, the
externality is internalized or the external cost of production is added to the
private cost. The following figure shows how taxation is used by the
government to internalize external cost.
Fig.1A.7-Externa l Cost and Use of Taxation.munotes.in

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Before the imposition of tax, the marginal private benefit curve D
= MPB intersects the supply curve at point E. Accordingly, price P1 and
quantity Q1 are determined. However, when the tax is imposed to cover
the external cos t, the supply curve shifts to the left and now intersects the
demand curve at point A. As a result, the new price is P2 and quantity
demanded is Q2. At Q2 level of output, the actual tax is P2P3 which is
divided between the buyer and the seller in equal proportion because the
price elasticity of demand is equal to one. The burden of tax shared by the
buyer is AC and that of the seller is CB.
Financial intervention by giving subsidies to correct market failure
caused by external benefits or positive exte rnalities can be explained as
under.
The equilibrium before government intervention is at point F
where MPB = MPC or Demand is equal to supply. When marginal
external benefit is added to the MPB curve, the MPB curve shifts to the
right and D 2= MSB curve is obtained. The MSB curve represents
society’s demand for the product. If the government subsidizes the
production of this product then the supply curve moves to the right from
S1= MPC to S 2= MPC –Subsidy. The marginal cost of supplying the
good is reduced by the amount of subsidy and the vertical distance GH is
equal to the value of the subsidy. The equilibrium after the subsidy is
given by point H where D 1intersects the supply curve S 2and the optimal
amount of goods Q 2is sold by the market.
Fig.1A.8: External Benefits and Use of Subsidies.munotes.in

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7. STATE PRODUCTION
Government may take over the production of a good or service
either in whole or in part. Industries such as the electricity, coal mining
and railway are entirely owned and man aged by the State in many
countries. It is also very common to find some goods and services being
produced by both the State and the private sectors. Education and health
care, for example, are provided both publicly and privately.
8. INCOME AND OTHER T RANSFERS
Income transfers are used by governments as a means of
redistributing income or transferring income from one group in society to
another group for example from people in work to those who are retired or
from relatively rich people to those who ar e in poverty. The justification
for these transfers is to achieve fairness or equity in an economy. These
transfers of income may be in the form of a cash benefit paid by the
government to someone with a low income. Income transfers may also be
used to cover the unexpected loss of income when a person is not working
due to illness or unemployment. These cash transfers include social
security benefits such as income support, job seeker’s allowance or a State
pension.
1A.5 SUMMARY
1. A market economy is one in which all goods and services are
voluntarily exchanged for money at market prices. A market economy
without government intervention maximizes output and therefore
maximizes economic welfare of the society. The term market failure
describes the fai lure of the market economy to achieve an efficient
allocation of resources.
2. An externality is said to arise if a third party is affected by the decisions
and actions of others or when there is a divergence between social cost
and social benefits, privat e costs and private benefits.
3. Market fails in both the cases of merit and demerit goods. A merit good
has positive externalities. A demerit good has negative externalities.
4.Public goods have two important characteristics. They are non -rival in
consumption and they are non -excludable. In contrast to public goods,
private goods are rival in consumption and divisible in consumption
and are also excludable.
5. The problem caused by public goods is that the market will fail to
provide public goods due to the problem of free riders. The market
will therefore not allocate resources for the production of public goods
although public goods are highly desirable from the society’s point of
view. Due to the problem of free riding, the market fails to register the
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6. Monopoly market and the problem of market failure can also be
explained with the economic concept of deadweight loss. Deadweight
loss refers to the loss of economic welfare caused by market
imperfections such as a monopoly market. The loss of both consumer
and producer surplus is known as Deadweight loss.
7.Market economies tend to generate wide income inequalities. Wide
income inequalities may lead to a range of social and economic
problems.
8. Imperfect information le ads to shortages and surpluses in the economy.
9.Government intervention in the market helps to correct market failures
and achieve an equitable distribution of resources in the economy.
10. The government uses many methods of regulation as a means of
controlling a market. Legal and other methods are used to control the
quality and quantity of goods and services that are produced and
consumed.
11. Government may take over the production of a good or service either
in whole or in part.
12. Income transf ers are used by governments as a means of redistributing
income or transferring income from one group in society to another
group for example from people in work to those who are retired or
from relatively rich people to those who are in poverty.
1A.6 QUE STIONS
1.Explain the concept of Market failure.
2.Explain the problem of externalities.
3.Explain the problem of merit and demerit goods.
4.Explain the problem of monopolies and deadweight loss.
5.Explain the concept of Externality.
6.Explain financial intervention b y the Government to correct market
imperfections.
7.Explain the concept of Public goods and economic role of
Government.
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UNIT -II
UNIT -2
DEMAND AND SUPPLY ANALYSIS
Unit structure
2.0 Objectives
2.1 Determinants of Demand
2.2 Demand Function
2.3 Market Demand Function
2.4 The Theory of Attributes
2.5 Snob, Bandwagon and Veblen Effects and Demand Function
2.6 The Law of Supply
2.7 Increase and Decrease in Supply
2.8 Vertical and Horizontal Shifts i n the Supply Curve
2.9Elasticity of Supply
2.10 Types of Price Elasticity of Supply
2.11 Determinants of Supply
2.12 Applications of Ped and Pes to Economic Issues
2.13 Estimat ion of Demand: Problems and Applications.
2.14 Measurement of Elasticity of Supply
2.15 Paradox of Bumper Harvest
2.16 Tax on Price and Quantity
2.17 Impact of Tax Imposed o nB u y e r s
2.18 Impact of Tax on Sellers
2.19 Maximum Price Ceiling
2.20 Price Floors and Market Outcomes
2.21 The Minimum Wage Controversy
2.22 Administered Price Control
2.23 Summary
2.24 Question s
2.0 OBJECTIVES
To study various Determinants of Demand
To study the Market Demand Function
To study the Theory of Attributes
To understand the concepts of Snob Appeal, Bandwagon and
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To study the Law of Supply
To understand the concept of Elasticity of Supply
To understand the Application of Elasticity of Demand Supply to
Economic Issues
To study the concept of Paradox of Bumper Harvest
To study the Tax on Price and Quantity
To understand Minimum Floor and Maximum Ceilings concepts
To study the Minimum Wages Controversy and Administered
Price Control
2.1 DETERMINANTS OF DEMAND
Demand can be studied in terms of individual demand and market
demand. Those factors which influences or determines individual demand
also go into determining market demand which is the sum of individual
demands. However, the same cannot be said of the factors which
determine market dem and. For instance, factors such as income and
wealth distribution, common habits, tastes and preferences of
communities, market size and population growth rate, business cycles, etc.
exclusively determine market demand. Factors such as prices of the given
products, disposable income of the individual, future expectations,
advertisement and sales propaganda, prices of substitutes and
complementary goods influence individual demand. However, these
factors with a greater magnitude also influence market demand.
A firm which is in the business of producing and selling niche
products and customized products which are targeted at certain categories
of people or communities and individuals should take into consideration
those factors which determine community speci fic and individual demands
for estimating market demand. While estimating demand for generalized
products or products for secular consumption, the following demand
determinants which influence market demand must be taken into
consideration.
(1)Price of the Pr oduct: The law of demand states “other demand
determinants remaining constant, when the price of a given
product falls, demand rises and vice -versa” . It means, if the price
of a given product falls, the market demand for the given product will
rise and if the price rises, the market demand for the product will fall.
However, the product under consideration should be a normal product
i.e. the consumers should not perceive the given product as an
‘inferior good’ or a ‘Giffen good’ or a ‘Veblen good’. The law of
demand is applicable to only normal goods and normal people.
(2)Size and the Rate of Growth of Income: The absolute size of the
income determines the quantum of goods and services produced in an
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be the demand for goods and services and vice -versa. In addition, the
rate of growth of incomes will determine the incremental growth in
demand for goods and services. Thus higher the rate of growth of
incomes, higher will be the quantity demanded by the people.
(3)Tax Exempt Level of Income and Tax Structure: The tax structure
and the tax exempt level of income determines the disposable income
of the people. It is the disposable income of the people that
determines market demand. Higher the tax exem pt level of income
and less steeply graded the tax structure, greater will be the disposable
income of the people and greater will be the market demand. For
instance, in India the tax exempt level of income is Rs. 2, 50,000 i.e.,
individuals with an annual income up to Rs. 2, 50,000 are exempt
from paying income tax. Between 2.5 lakh and 5.0 lakh, the tax rate is
05% and between 5 and 10 lakh the tax rate is 20%. The marginal rate
of taxation is 30% which is applicable to annual incomes above Rs.
10 lakh. T he changes in the income tax structure were announced in
the Union Budget 2020 -21. If the government raises the tax exempt
limit in the next budget, individuals in each income category will save
more money and their disposable income will accordingly ris e.
(4)Level of National Income and its Distribution in the Community:
A more equitable distribution of national income and wealth in the
community means that the lower sections of the society have sizeable
purchasing power and since the low and middle class people has a
greater propensity to consume than the upper class people; the
demand for goods will be high. The relatively poor will be spending a
larger proportion of their income on consumption and hence a more
equitable distribution of national income en sures higher level of
demand for goods and services produced in an economy by the firms.
However, equitable distribution alone will not determine the level of
demand. The size or the level of national income is also important.
For instance, the Gini Index for India and the United States were 33.6
and 41.1 respectively in the years 2012 and 2013. The Gini index
measures the extent to which the distribution of national income
deviates from a perfectly equal distribution. A Gini index of zero
represents perfec t equality and an index 100 represents perfect or
maximum inequality. The Gini index reveals that income distribution
in India is more equal than the United States. However, the national
income of India and United States for the year 2016 was US $ 2.29
trillion and US $ 18.55 trillion and the per capita income for the two
countries was US$ 1820 and US $ 57,220 respectively. While the
national income of US was 8 times higher than India in 2016, the per
capita income was 31.4 times higher than that of India. Now that
explains why the average American is well dressed and well fed and
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(5)Spending Habits, Customs and Preferences: A spend thrift society,
high on consumerism and believing in enjoying the mat erial comforts
and luxuries of life will not only produce more but also consume
more. A society which is well clad, eats well, drinks well and enjoys
life will generate more demand for goods and services. A thrifty and
conservative society will not be inte rested in the consumption of
value -added goods and services. If the consumption pattern of the
society is determined by customs and traditions, the level of demand
will be less and the demand will be for goods with low value addition.
For instance, in a co untry like India, a considerable amount of income
is generated without going through the market or exchange
mechanism. This can be explained in terms of peoples’ preference for
food items made at home (by self or other family members). The
labor that goes into making food and managing the household is not
transacted through the exchange mechanism. This leads to a much
lower level of national income and spending. A society which prefers
ready to eat food, ready to wear clothes and ready to live house and
enjoy the weekends will generate more demand.
Paradoxically, in a poor country like India, the demand for gold is not
only huge but also ever increasing, making India the largest consumer
of gold in the world. The demand for gold in India is driven by stupid
customs and gold worth Trillions of rupees is hoarded by households.
Money that should otherwise go into accelerating economic growth is
left to rot like deadwood in the 200 million jewel boxes of the
approximate 200 million households in India.
(6)Market S ize and Growth rate of Population: The number of buyers
for a given product constitutes the size of the market. Larger the
number of buyers, larger will be the market size and greater will be
the demand for a given commodity. Market size depends upon the
growth rate of population and the age structure of a society. The
goods and services demanded by a young population will be different
from that of an ageing population. For instance, population in India
can be characterized as young because it has the large st number of
persons in the age -group 15 -59 whereas Japan can be said to have an
ageing population because it has a considerable number of people in
the 59 + age group.
The sex ratio i.e. the number of females per 1000 of male population
will also determi ne both pattern and the quantum of demand.
Economically independent and empowered women will determine the
quantum of demand for female specific goods. For instance, the
number of females per 1000 male population in Kerala in 2011 was
1084 whereas the all India average was only 943. In order to ensure
sustained growth in demand for goods and services, it is not enough to
have a sustained growth in income but also a sustained growth in
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populous c ountries like India is undesirable where economic
prosperity of the available people is the key to sustained rise in
demand. Thus, the size and growth of population, the level and spread
of economic prosperity, the age structure and the extent of individua l
economic empowerment will determine the extent of demand and the
pattern of demand in an economy.
(7)Price Related Expectations: Price stability leads to stable
expectations. For instance, if the current rate of inflation or general
price rise is 5 percent and the expected inflation rate in the future or
subsequent year is also 5 percent, there will be no fluctuation in
demand on account of expectations. However, if people expect that
future inflation rate will be substantially higher than the present rate,
the demand will rise even when the prices are rising. Similarly, if the
future expected price rise is less than the present one or if the people
expect the prices to fall in the future, the demand will continue to
contract even when the prices are actuall y falling.
Expectations, though, psychological and sometimes objective have an
important role in determining the present level of demand. For
instance, during the real estate boom of 1985 -95, the demand for real
estate was continuously rising in -spite of the sky -rocketing real estate
prices. However, during the post 95 real estate bust, the prices began
to fall absolutely until the year 2000 by which time the real estate
prices were half the prices in 1995 which was the peak of the boom.
Demand continued t o be sluggish in -spite of the stable real estate
prices and housing loans being available on demand in the years
2014, 2015 and 2016 because the real estate prices had peaked and the
market was expecting a correction in the prices. The same is true in
thepost-Corona times that we are living in.
(8)Prices of Substitutes and Complementary Goods: The demand for
a commodity will be not only determined by its own price but also the
prices and changes therein of substitutes and complementary goods.
Tea and coff ee, fountain pens and ball pens, sugar and jaggery beef
and mutton or beef and chicken or mutton and chicken, vegetable
ghee and vegetable oil, diesel and petrol, etc. are examples of
substitute goods. Tea and sugar/milk, coffee and sugar/milk, fountain
pen and ink, ball -pen and refill, car and petrol, bread and butter, etc
are examples of complementary goods. In case of substitute goods,
the cross price elasticity of demand is greater than zero i.e. for
instance, if we take two substitute goods tea and cof fee and assume
that the price of tea remains constant but that of coffee rises, the result
will be in the form of rise in demand for tea, although the price of tea
did not change, and fall in the demand for coffee. Similarly, if petrol
prices rise and dies el prices remain constant, the demand for petrol
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The change in demand for substitutes and complementary goods is
price -initiated. In the case of complementary goods, the demand for
either of the commodities will fal l with a rise in the price of one of the
commodity, the price of other commodities remaining constant and
vice-versa. For instance, if price of sugar rises, the demand for sugar,
tea and milk will fall or if the price of butter falls, the demand for
both b utter as well as bread will rise.
(9)Business Cycles: Cyclical fluctuations cause fluctuations in demand.
Both recession and prosperity can be industry wide or economy wide.
Even when the economy as a whole is passing through a recessionary
phase of the busi ness cycle, some industries may experience
prosperity and sometime the economy may be prospering but some
industries may be in the grip of recession. However, broadly
speaking, during the prosperity phase, business is booming and
market demand is rising, w hereas during a recessionary phase, there is
a general slump in the business activity and there is a continuous fall
in market demand leading to sustained fall in the growth rates of the
economy as well as the firms. In the aftermath of the 1991 economic
crisis in India and with the adoption of the new economic policy, the
government’s capital expenditure was considerably reduced which
resulted in a recession in the capital goods industry. The growth in
GDP since 1998 -99 has been on the decline until 2000 -01 indicating a
recessionary trend in the Indian economy. Thereafter, there has been a
spectacular increase in the growth rate of GDP, particularly after
2003 -04 and up to 2007 -08. The Global Financial Crisis of 2008 -09
affected the growth rate in India an d the growth rates fell in 2008 -09
and 2009 -10. The growth rates continued its downward trend till
2013 with an all -time low of 5.1 per cent. Thereafter the growth rate
has once again assumed an upward trend until 2016 -17 when it
peaked at 8.26%. After 2016 -17, the growth rate began its downward
spiral and in the year 2019 -20, the GDP growth rate reached a new
low of 4.18%.
(10)Inventions and Innovations: Both inventions and innovations
generate additional market demand. While inventions bring in entirely
new products to the market, create a new need and generate new
demand, innovations result in more convenient, and more useful and
more efficient products. For instance, the advent of the personal
computer has practically finished the typewriter manufacturi ng firms.
Today fresh demand for typewriter is nil. The introduction of cable
TV created the demand for multiple channel TV sets. As a result, TV
sets with few channels and few functions become obsolete. The
electronics industry is continuously innovating, thereby increasing the
rate of obsolescence and simultaneously generating new demand for
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(11)Climate: Market demand for certain products changes along with the
change in the climate. While the demand for soft drinks changes or
rises d ramatically in the hot summers, the demand for wine increases
during the winters. Seasonal products like the woolen wear and rain
wears will have demand only during their respective seasons and
almost nil demand when the season is over. The demand for tea
increases during the winters and the demand for cotton fabrics go up
during the summers. Climatic changes, does influence market
demand.
(12)Advertisement: There is no perfect competition in reality. The food
grain and vegetable market, the meat or fish marke t may be near
perfect and hence they need not advertise. A large number of goods
and services that we consume in the modern times are either produced
by monopolistic or oligopolistic firms. Product differentiation, price
discrimination and advertising are the distinguishing features of the
firms operating under these market structures. Without advertising
these firms will never grow and their products will never be known
for their distinct identities. Advertising creates brand consciousness. It
creates dema nd where it doesn’t exist. It creates new needs when
people actually may not need it. It creates brand loyalty and it shifts
brand loyalty. Advertising keeps the capitalist markets in a continuous
flux. Even a top line product will have very little or no d emand, if the
product is not advertised. Advertisement keeps the market demand
growing and ever growing.
To this list of determinants, one may add the general state of
medical health in a given economy. If a country or a great of the country
is affected by bad health condition such as disease and epidemic, the
demand for goods and services will be adversely affected. For instance, in
the post -Corona times, the projected growth rate of GDP by Moody’s
Investor Service for India for the year 2020 -21 is zero per cent. Other
agencies such as Goldman Sachs, Fitch and ICRA has also projected a
contraction of five per cent in the economy which means growth rate of
GDP in 2020 -21 is going to be negative. The only agency which has
clearly stated that Indian growt h rate will be minus five per cent is
CRISIL. The Indian economy will be in the grip of recession and
therefore there will be less demand.
2.2 DEMAND FUNCTION
The quantity demanded of a given commodity is not only an
inverse function of the price but al so a number of other factors. These
factors are income of the consumer, prices of substitutes and
complementary goods, taste and preference of the consumer, expected
future prices and other factors. A simple demand function can be stated as
Dx=-f(Px). It reads that quantity demanded of commodity ‘x’ (D x)i sa
negative function of price (P). However, the demand function must factormunotes.in

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in all possible demand determinants and therefore a more comprehensive
demand function can be stated as follows:
Dx=f( P x,Py,Pc,Ps,Y ,E ,T ,A ,U )
Where D x= Quantity demand of commodity ‘x’
Px= Price of commodity ‘x’
Ps= Price of substitutes
Pc= Price of complementary goods
Y= Income of the consumer
E= Price expectation of the consumer
T= Taste and preferenc e of the consumer
A= Advertisement expenditure
U= Other factors.
The impact of demand determinants on the quantity demanded of a
given commodity is explained in the section on demand determinants.
The simple demand function Dx = –f (Px) does not rev eal the
change in the quantity demanded of commodity ‘x’ as a result of a
percentage change in the price. It does not reveal the quantitative
relationship between Dx and Px. It only reveals the functionally inverse
relationship between Dx and Px. When you are aware of the quantitative
relationship between independent variable Px and the dependent variable
Dx, the demand function can be written in the form of an equation: Dx = a
–bPx, where ‘a’ is a constant denoting the total demand when price is
zero and ‘b’ is also a constant which refers to the change in the quantity
demanded of commodity ‘x’ as a result of change in the price of ‘x’
(D/P).
The equation Dx = a –bPx represents a linear demand function. A
demand function is said to be linear when it gi ves a linear demand curve.
For instance, if we substitute the values of ‘a’ and ‘b’ with 200 and 10
respectively, the demand equation can be stated as:
Dx = 200 –10 Px
The above demand equation reveals that Dx = 200 when Px = zero
and Dx = Zero when Px = Rs. 20/ –per unit of ‘x’. These are the two
extreme ends of the demand curve and they are obtained as follows:
Px= 200 10 = 20
Dx = 200 –10(20) =Zero
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Similarly, when Px is Zero, Dx = 200 i.e. Dx = 200 –10(0) = 200. The
demand equation also reveals that for every one rupee rise in the Px, Dx
will fall by 10 units i.e., when Px = Re. 1, Dx = 190 and this can be
obtained as follows:
Dx = 200 –10(1) = 190
In this way, between the two extreme ends of the demand curve, the
different price and quantity relationships can be established. By
substituting the numerical values of Px, a demand schedule can be
prepared as follows:
Table 3.1: Demand Schedule
Px Dx = 200 –10 Px Dx
0 200–10(0) 200
5 200–10(5) 150
10 200–10(10) 100
15 200–10(15) 50
20 200–10(20) 0
When the data obtained in the above table is plotted on a graph, a linear
demand curve will be obtained as shown in figure 2.1:
0Dx=200-10Px
Price(Px)
Quantity(Dx)5101520
50100200Fig.2.1 Linear Demand Function
You will notice from the above figure that the linear demand curve
has a constant slope ( Px/Dx). The price function can be obtained from
the demand function as follows:
Px=a–Dx
b
or
Px=a
b–1
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Substituting the values of a, Dx and b in the above equations, the
values of Px can be obtained as follows:
(1) Px=200–200
10=0
10=0
or
Px=200
10–1
10(200)
= 20 –20 = 0
(2) Px=200–150
10=50
10=5
Or
Px=200
10–1
10(150)
= 20 –15 = 5
(3) Px=200–100
10=100
10= 10
Or
Px=200
10–1
10(100)
= 20 –10 = 10
(4) Px=200–50
10=150
10= 15
Or
Px=200
10–1
10(50)
= 20 –5 = 15
(5) Px=200–0
10=200
10= 20
Or
Px=200
10–1
10(0)
=200
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If we assumea
b=a1and1
b=b1,then the price function can be
restated as:
Px=a1–b1Dx
Case study 1:
M/s. Pietermaritzburg Cookies conducted a survey to find out the daily
demand for cookies and found that the average daily demand for cookies
was given in the form of the following dema nd equation:
DC= 10,000 –50 P C
Questions:
(1)How many kilograms of cookies will be sold daily, if the price of
cookies per kilogram is Rs. 120/ –?
(2)What price should be fixed if M/s. Pietermaritzburg cookies want to
sell 7500 kgs of cookies per day?
(3)What wi ll be the price if the daily average demand for cookies is 5000
kilograms?
(4)At what price the daily average demand for cookies will be zero?
(5)Draw a demand curve on the basis of the demand equation:
DC= 10,000 –50 P C
Solution:
(1)At Rs. 120 per kg, the total demand for cookies will be:
DC= 10,000 –50(120) = 4000
Ans. 4000 kilograms per day.
(2)In order to sell 7500 kilogram of cookies per day, the price per
kilogram can be obtained as follows:
PC=a-DC
b
PC=10‚000 -7500
50=2500
50= 50
Thus at Rs. 50 per kilogram, demand for cookies will be 7500 kilo -
grams per day.
(3)At an average daily demand of 5000 kilogram of cookies, the price of
cookies per kilogram will be:
PC=10‚000 -5000
50=5000
50= 100
Thus at Rs. 100 per kg, the demand for cookies will be 5000 kilo -
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(4)The average daily demand for cookies will be zero, when the price of
cookies per kilogram is:
PC=10‚000 -0
50= Rs. 200
Thus at Rs. 200 per kg, the demand for cookies wi ll be zero.
(5)In order to draw a demand curve, a demand schedule on the basis of
the given demand equation needs to be constructed. Let us therefore,
construct a demand schedule.
(6)
Table 2.2: Demand Schedule
PC DC= 10,000 -50 P C DC
0 10,000 -500 10,000
50 10,000 -5050 7,500
100 10,000 -50100 5,000
150 10,000 -50150 2,500
200 10,000 -50200 0
When we plot this demand schedule on a graph, we obtain a linear
demand curve as shown in figure 2.2:
0PriceofCookies(Pc)(Rs.Perkg)
DemandforCookies(kgsPerDay)50100150200
5000 1000020000Dc=10,000-50Pc
Fig.2.2 Linear Demand Functionmunotes.in

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2.3 MARKET DEMAND FU NCTION
Market demand for a given product is the sum of individuals
demand for the said product given the price, place and time. The market
demand function can be stated as follo ws:
MDx=f( P x,Y ,P sc,T ,A ,N ,U )
where MDx= Market demand for commodity ’x’
Px= Price of commodity ‘x’
Y= Income
Psc= Prices of substitutes and complementary goods
T= Tastes and preferences
A= Advertising outlay
N= The size of the population or the consumers
U= Other factors
In order to estimate the market demand for a given product, a
linear market demand function is used. Such a linear market demand
function is stated below:
MDx=C+b 1Px+b 2Y+b 3Psc+b 4Pc+b 5T+b 6A+b 7N+b 8U
Here, C is a constant term which is the intercept of the market demand
curve on the x -axis. b 1,b2,b3, etc. are coefficients which show the
quantitative relationship of the independent variables with the market
demand. These coefficients show the extent of change in market demand
as a result of a change in variables such as price, income, taste, population,
etc. A simplified version of the market demand function can be stated as
below:
MDx=C+b 1Px
Here ‘C’ is the constant term which shows the intercept of the market
demand curve on the x -axis and b 1is the coefficient indicating the extent
of change in the market demand for commodity ‘x’ as a result of change in
the price of commodity ‘x’. In th is simplified version, we have assumed
that only P xis the variable factor and all other factors such as the income,
tastes, habits, preference, population, advertising, etc are constant. In
effect we can say that it is the short run market demand function although
advertising expenditure does influences market demand irrespective of the
time period. A market demand schedule is given in table 2.3 which shows
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Table 2.3: Market Demand Sch edule.
Price of
Potatoes
Rs./kgQuantity
Demanded by
Consumers (in kgs)Market
Demand
(ABC)
A B C
1 2 3 4 5
12 1.00 0.75 0.25 2.00
10 1.50 1.00 0.50 3.00
08 2.00 1.25 0.75 4.00
06 2.50 1.50 1.00 5.00
04 3.00 2.50 1.50 6.00
We have assumed that there are three consumers in the market,
namely, A, B and C. As can be seen that the market demand is only a
summation of individual demand of A, B and C at the given prices of
potatoes and the demand function is clearly negative i.e. the inverse
relations hip between prices and quantity demanded can be seen all over
the table. Individual demand curves can be drawn for individuals A, B and
C on the basis of available information in Table 3.3. In order to draw the
market demand curve, we plot the data on pric es given in column 1 and
the data on market demand given in column ‘5’ of Table 3.3. A market
demand curve drawn on the basis of these data is given in figure 3.3
below.
0PRICE(Rs.)
1M
DMarket Demand Curve
2 3 4 5 6 7 xy12
Quantity Demanded
of Potatoes (kgs)10
8
6
4
2
Fig.2.3 Market Demand Curve
The market demand curve in Fig. 2.3 slopes downwards from left
to right as in the case of individual demand curve in Fig. 2.2.munotes.in

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Check your progress
1. bring out the relationship between demand and its determinants.
2. Explain the concept of demand function.
3. What do you understa nd by market demand function?
____________________________________________________________
____________________________________________________________
____________________________________________________________
______________________________________________ ______________
____________________________________________________________
2.4 THE THEORY OF ATTRIBUTES
Kelvin Lancaster (Consumer Demand: A New Approach, New York,
Columbia University Press, 1971) put forward the characteristic or
attributes approach t o consumer theory. Kelvin says that consumers
demand a good because of the characteristics, properties and attributes of
the good which give rise to utility. For example, a consumer does not
demand eggplant for itself but because egg plants satisfy the d emand for
calories and proteins. Calories and proteins contained in a food product
are the direct source of utility rather than the product itself. However,
proteins and calories are provided by other vegetables such as spinach and
cauliflower also. A c ommodity has more than one attribute and any given
attribute is present in more than one commodity.
The consumer theory of attributes can be shown as in figure 2.4.
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Figure 2.4 The Attribute Theory of Consumer Demand.
In Panel ‘A’ of Figure 2.4,the X -axis measures the attribute of
protein and the Y -axis measures calories. Let us assume that the
consumer’s income is Rs.100 and that Rs.50 worth of Spinach provides
the combination of protein and calories given by point A (A unit of
spinach protein is assumed to provide four times calories as much as a unit
of Mustard Green protein because the slope of the Spinach ray is four
times larger than the Mustard Green ray) and Rs.50 worth of Mustard
Green gives the combination at point B. The budget line i s AB and Area
OAB is called the feasible region and budget line AB is the efficiency
frontier. The consumer can purchase any combination of protein and
calories in AOB. In order to maximize utility, the consumer will choose a
combination on budget line A B. If U 1is the indifference curve in the
attributes space, the consumer maximizes utility at point C where
indifference curve U 1is tangent to budget line AB. The consumer reaches
point C by obtaining OF attributes by spending Rs.50 on Mustard Green
andFC attributes by spending Rs.50 on Spinach. OF = ½ OB and OG = ½
OA. FC equals OG both in length and direction be noted.
In Panel B, egg -plant, a new commodity is introduced. Egg -plant
has half as many calories per unit of protein as Mustard Green. If Rs.100
worth of egg -plant provides the combination of protein and calories given
by point H, the budget line or efficiency frontier becomes AH. The
consumer now maximizes utility at point J where indifference curve U 2is
tangent to budget line AH. The co nsumer reaches point J by obtaining OK
attributes by spending Rs.50 on egg -plant and KJ = OG attributes by
spending the balance Rs.50 on Spinach. The consumer ignores Mustard
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A fall in the price of a commodity is shown by a proportionate
outward movement along the attributes ray of the commodity. An
increase in income is shown by a proportionate outward shift of the entire
budget line. A shift in the budget line allows the consumer to reach a
higher indifference curve.
2.4.1 Advantages of the Attribute Theory
The Attributes theory of consumer behavior has many advantages
over the traditional theory of demand. These advantages are as follows:
1.The substitution between goods can be explained in terms of some
common attributes of the goods. For example, spinach and mustard
greens are substitutes because they both have the common attribute of
being protein rich. And if you are looking for proteins as an attribute
then Egg -plant becomes a distant substitute because egg -plant is a
fleshy vegetable whereas spinach and mustard green are leafy
vegetables.
2.A new commodity can be easily introduced in the model by drawing a
new ray from the origin reflecting the combination of the two
attributes of the new commodity as shown by the introduction of egg -
plant in Panel B. However, egg plants will be purchased only if its
price is adequately low. If Rs.100 worth of egg -plant had provided
only the combination of protein and calories given by point K on the
attributes ray for egg -plant, the budget line would become ABK and
the consumer would maximize utility by remaining at point C. The
consumer would not purchase egg -plant in that case.
3.A change in the quality of the product can be shown by rotating the
attributes ray clockwise. For example, the introdu ction of a new
variety of spinach with less calories per unit of protein.
4.By comparing the price of two goods that are identical except for a
particular attribute, the attributes theory allows for the estimation of
the implicit price of the attribute. Fo r example, by comparing the
prices of identical houses with differences in attributes such as away
from the railway station and the market place, peaceful neighborhood
with good schools, parks and transportation facilities, the implicit price
of each of th ese attributes can be estimated. Thus if the price of a
house away from the railway station and the market place with the
aforesaid attributes is 10% more than the price of another identical
house that is near the railway station, then the house with the attribute
of a peaceful neighborhood and other facilities is worth 10% of the
price of the house that is around the railway station.
The attributes theory of consumer behavior cannot measure
attributes such as taste and style which are subjective in natur e. The
theory cannot measure the attributes of services. However, the attributesmunotes.in

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approach to consumer behavior is useful because it allows for the implicit
measure of the different attributes of a commodity. (Reference: p103 -105,
Ch.4 –Consumer Behavio r and Individual Demand, Principles of
Microeconomics, 5thedition, Dominick Salvatore, Oxford International
Student Edition).
2.5 SNOB, BANDWAGON AND VEBLEN EFFECTS AND
DEMAND FUNCTION
The market demand curve for a commodity shows the various
quantities of the commodity demanded in the market per unit of time at
various alternative prices while other factors determining demand remains
constant. The market demand curve is the horizontal summation of the
individual demand curves only if the consumptions d ecisions of individual
consumers are independent i.e. their decisions are not influenced by
network externalities. Network externalities may be negative or positive.
If the network externality is negative, consumers will demand less at the
given price an d the demand curve will become steeper. In case of positive
network externality, the consumers will buy more of a commodity at the
given price and the demand curve will become flatter. The effects caused
by network externalities are classified into snob, bandwagon and Veblen
effects.
1.Bandwagon Effect. Sometimes people demand a commodity because
others are buying it. In order to keep with the consumer trends or
fashion or because the commodity is more useful, more and more
consumers buy the given product. As a result, the demand for the
commodity rises at the given price. This is known as Bandwagon
Effect or positive network externality. Due to the bandwagon effect,
the market demand curve becomes flatter or more elastic.
2.Veblen Effect. Prof. Thorstein Veblen found that expensive goods
have prestige value and hence their consumption increases along with
the rise in price and vice -versa. Conspicuous or remarkable
consumption is an exception to the law of demand. There are
categories of people who do not like to be associated with cheap goods
and services. Such people are believed to be indulging in conspicuous
consumption. For instance, goods like precious stones and haute
couture have a Veblen effect and are believed to be ostentatious. The
demand curve for such goods is also steeper or less elastic.
3.Snob Effect. When consumers seek to be different and exclusive by
demanding less of a commodity as more people consume it, the snob
effect occurs. Snob effect is due to a negative network externality.
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A change in the future price expectations will affect the demand
curve. For example, if future prices are expected to fall, less will be
demanded at the current price and the market demand curve will shift to
the left. Conversely, if future prices are expected to rise, more will be
demanded at the current price and the market demand curve will shift to
the right.
According to Dominick Salvatore, network -externalities do not
make the demand curve positive s loping because there is no empirical
evidence to the belief that snob, bandwagon and Veblen effects could lead
the market demand curve to have a positive slope.
Check your progress:
1. Who advocated the Theory of Attributes?
2. What are the advantages of the Theory of Attributes?
3. Mention the effects caused by network externalities.
____________________________________________________________
____________________________________________________________
______________________________________________________ ______
____________________________________________________________
___________________________________________________________
2.6 THE LAW OF SUPPLY
Supply refers to the quantities of a commodity which the seller is
willing and able to provide at differen t prices during a given period of
time, other things remaining constant. Supply of a commodity is a direct
function of its price. Ceteris paribus, higher the price, higher will be the
quantity supplied and vice versa. This is known as the law of supply. It is
based on the assumption that except price, all other supply determining
factors such as cost of production, state of technology, production
capacity, government policies, price level, prices of related goods etc
remain constant. The law of supply can be explained in terms of
individual and market supply curves. Both individual and market supply
can be explained with individual and market supply schedules and the data
in these schedules can be plotted on a graph to obtain individual and
market supp ly curves. A hypothetical individual supply schedule is given
in Table 2.4 and the individual seller’s supply curve is shown in Figure
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Table 2.4
A Hypothetical Individual Supply Schedule for Bananas.
The quantity of bananas supplied per day is directly related with
the price. Higher the price of bananas, higher will be the quantity of
bananas supplied by the individual seller. The individual seller is willing
to supply more at a higher price because the cost of producing the
marginal unit increases after a point. The law of diminishing marginal
returns operate to increase the cost of production after a point and hence
the operation of the law of suppl y. The law of supply states that, ‘other
things remaining constant, the quantity supplied of a commodity will be
greater at a higher price and vice versa’. The individual supply curve
drawn by using the data from Table 2.4 will have an upward or positiv e
slope. The supply curve will slope from left to right in the upward
direction. This is shown in Figure 2.5. The market supply curve is the
sum of individual supply curves. Let us assume that there are three
banana sellers in the market and given the prices these three sellers would
be supplying various quantities of bananas to the market.
Fig2.5–Individual Supply Curve.Price per Dozen
(INR)Quantity Supplied
(Dozens/day)
10 10
15 20
20 30
25 40
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A hypothetical market supply schedule is given in Table 2.5.
Table 2.5
A Hypothetical Market Supply Schedule for Bananas.
Based on the data given in Table 2.5 above, the market supply s chedule is
drawn in Figure 2.6.
Fig.2.6–Market Supply Curve.
Given the prices mentioned in Table 2.5, suppliers A, B and C
supply various quantities of bananas according to their willingness and
capacity to supply. The market supply at each of these prices is the sum of
quantities supplied by individual suppliers. Thus at a price of Rs.10 per
dozen, the market supply is 25 dozens and as the price goes up, the market
supply also goes up to 100 dozens at a maximum price of Rs.40 a dozen.
The mar ket supply curve is a horizontal summation of individual supply
curves. The market supply curve is flatter than the individual supply
curve because more of a quantity is supplied at the given price. The
movement along the supply curve as a result of chan ges in price is alsoQuantity Supplied
(Dozens/day)Price per Dozen
(INR)
A B CMarket
Supply
MS = A+B+C
10 10 8 7 25
20 20 16 14 50
30 30 24 21 75
40 40 32 28 100
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known as extension and contraction in supply. Thus with a rise in price,
there is an extension in supply whereas with a fall in price, there is a
contraction in supply.
The law of supply, however, will not operate under the followi ng
circumstances. These circumstances are also known as exceptions to the
law of supply.
1. When sellers expect future prices to fall, the present supply of
commodities will increase. Conversely, if sellers expect future
prices to rise, they will reduce pr esent supply in order to profit
from higher future prices.
2. The supply of factor inputs such as labor may fall when the wage
rate rises beyond a point and the labor supply curve may assume a
backward slope. Labor being a human factor of production may
value leisure more than work at higher wage rates and hence would
be willing to sell a smaller quantity of labor at high wage rates.
The backward bending supply curve is depicted in Fig.3.7 below.
At W 0wage rate, L 0hours of labor is supplied. When the wa ge
rate rises to W 1, the hours of labor supplied also rises to L 1.
However, when the wage rate rises to W 2, the hours of labor
supplied falls to L 2which is less than L 1hours of labor supplied at
a lower wage rate W 1. Note point ‘b’ as the point of infle xion on
the labor supply curve SL. After point ‘b’, the labor supply curve
SL assumes a backward slope indicating that any rise in wage rates
after W 1will lead to a fall in hours of labor supplied.
Fig.2.7–Backward Bending Labor Supply Cu rve.munotes.in

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2.7 INCREASE AND DECREASE IN SUPPLY
A movement along the supply indicates rise and fall in the quantity
supplied as a result of change in price. Price remaining constant, when
other supply determining factors change, there is either an increase or a
decrease in supply and as a result, the supply curve changes its position.
Thus with an increase in supply, the supply curve will shift to the right and
with a decrease in supply, the supply curve will shift to the left. The shifts
in the supply curve are shown in Figure 2.8.
In Fig. 2.8, the original supply curve S 0shows that at price P 0, the
quantity supplied is Q 0. When there is a positive change in the supply
determining factors other than price, the supply curve shifts to the right
and a larger q uantity Q 1is supplied at the original price P 0. However,
when there is a negative change in the supply determining factors other
than the price, the supply curve shifts to the left and a lesser quantity Q 2is
supplied at the original price P 0. Thus, a h orizontal shift of the supply
curve to the right indicates that a larger quantity of goods will be supplied
at the original price, whereas a horizontal shift to the left indicates that a
lesser quantity will be supplied at the same price.
Fig.2.8–Increase and Decrease in Supply.munotes.in

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2.8 VERTICAL AND HORIZONTAL SHIFTS IN THE
SUPPLY CURVE
When the supply curve shifts its position, it also indicates that the
firm would be willing to supply the same quantity at a higher price or a
lower price. For instance, when the supply curve shifts to the left, the firm
would be willing to supply the original quantity at a higher price or a
lower quantity at the same price. A horizontal shift to the left would
indicate that a lower quantity is being supplied at the same price, whereas
a vertical upward shift would indicate that the same quantity would be
supplied at a higher price. Conversely, when the supply curve shifts to the
right, the firms would be willing to supply the original quantity at a lower
price or a larger quantity at the same price. A horizontal shift to the right
would indicate that the firms would be willing to supply a larger quantity
at the same price, whereas a vertical downward shift would indicate that
the firms would be willing to suppl y the same quantity at a lower price.
This is shown in Figures 2.9 and 2.10. Figure 2.9 indicates that when the
supply curve shifts to the left, the firm is willing to sell the same quantity
at a higher price P 1or a lesser quantity Q 1at the original pr ice P 0.
Conversely, when the supply curve shifts to the right, the firm is willing to
supply the same quantity at a lower price P 1or a larger quantity Q 1at the
original price P 0.
Fig.2.9–Horizontal Shift to the left and Vertical Upward shift in th e
Supply Curve.munotes.in

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Fig.2.10–Horizontal Shift to the Right and Vertical Downward Shift
in the Supply Curve.
2.9 ELASTICITY OF SUPPLY
Elasticity of supply refers to the responsiveness of quantity
supplied of a commodity to a change in supply determinan t. The Price
Elasticity of Supply can be defined as a percentage change in the quantity
supplied of a commodity as a result of percentage change in the price of
the commodity. Symbolically, the price elasticity of supply can be stated
as follows:
PES = Percentage change in quantity supplied
Percentage change in price
The co -efficient of price elasticity of supply can be derived with
the help of the following formula. This formula measures point price
elasticity of supply. The co -efficient of price elasticity denotes only small
or marginal changes. It thus measures elasticity at a point on the supply
curve.
PES =Q
QP
P=Q
QP
P
=Q
OPP
Q=Q2-Q1
P2-P1P1
Q1
Where Q = O riginal quantity supplied,
P= Original price,
Q= Change in quantity supplied (Q 2-Q1), and
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The price elasticity of supply is a numerical measure of the
responsiveness of the quantity supplied of given product ‘X’ to a change
in price of product ‘X’. It is the measure of the way quantity supplied
reacts to a change in price. For instance, if, in response to a 15% rise in
the price of a good, the quantity supplied increases by 15%, the price
elasticity of supply would b e 15%/15% = 1. When there is a relatively
inelastic supply for the good the coefficient is low. For example, if, in
response to a 10% rise in the price of a good, the quantity supplied
increases by 5%, the price elasticity of supply would be 5%/10% = 0. 5.
When supply is highly elastic , the coefficient is high. For instance, if, in
response to a 10% rise in the price of a good, the quantity supplied
increases by 20 per cent, the price elasticity of supply would be 20%/10%
= 2. Supply is normally more el astic in the long run than in the short run
for produced goods. As spare capacity and more capital equipment can be
utilized the supply can be increased, whereas in the short run only labor
can be increased. Goods that have no labor component and are not
produced cannot be expanded. Such goods are said to be "fixed" in supply
and do not respond to price changes. The quantity of goods supplied can,
in the short term, be different from the amount produced, as manufacturers
will have stocks which they can bui ld up or run down.
The determinants of the price elasticity of supply are as follows:
1.The existence of the naturally occurring raw materials needed for
production. Greater the availability of naturally occurring raw
materials, higher will be the elastic ity of supply and vice versa. Firms
would be able to respond to rise in prices by quickly increasing the
production and hence the supply of commodities. Thus countries and
regions with abundant supply of naturally occurring raw materials will
have a rela tively elastic supply curve and those countries and regions
with relatively less natural resources will have a relatively inelastic
supply curve.
2.The length of the production process or the production time required to
produce commodities. The production time required for producing
consumer goods is relatively lesser than producer or capital goods.
Thus consumer goods industry will be able to respond more quickly to
higher prices than capital goods industry. Similarly, perishable goods
will have inelast ic supply because they cannot be produced on a large
scale and stored for a longer time, whereas durable goods can be
produced on a large scale and also stored. Since supply is a part of the
stock, greater the stock, greater will be the responsiveness of supply to
a change in price. The supply curve for perishable goods will be
relatively inelastic and for durable goods, it will be relatively elastic.
3.The production spare capacity or excess capacity in the industry. The
more the spare capacity there is in an industry, the easier it should be
to increase output if the price goes up. Thus, if there is more excess
capacity, the elasticity of supply would be high. In the absence ofmunotes.in

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excess capacity and if the firms in an industry are operating at their
full capacity, the price elasticity of supply would be zero and the
supply curve will assume a vertical slope.
4.The mobility of factors of production also determines the elasticity of
supply. If factors of production such as labor, capital and enterprise
areperfectly mobile between the industries, the elasticity of supply
would be higher. If factor inputs are relatively less mobile, the price
elasticity of supply would be low. Further, the time required for factor
inputs to move from one industry to the ot her will also influence the
elasticity of supply. Lesser the time required for factor inputs to move
from one industry to the other, greater will be the elasticity of supply
and vice versa.
5.The storage capacity of producers and traders will influence the price
elasticity of supply. If they have more goods in stock, they will be
able to respond to a change in price more quickly.
2.10 TYPES OF PRICE ELASTICITY OF SUPPLY
The numerical co -efficient of price elasticity of supply is between
zero and infinity . Thus there can be five possibilities of price elasticity,
namely PES = 1, PES< 1, PES > 1, PES = 0 and PES = . These five
values of co -efficient assume the following five types of price elasticity.
Normally, supply curves have positive slopes and henc e supply elasticity
is normally positive.
1.Perfectly elastic supply (PES = ).
2.Perfectly inelastic supply (PES = 0).
3.Unitary elastic supply (PES = 1).
4.Relatively elastic supply (PES > 1).
5.Relatively inelastic supply (PES < 1).
1. Perfectly Elastic or Infi nitely Elastic Supply
When supply is infinite or unlimited at the given price, it is said to
be perfectly elastic or infinitely elastic supply. The numerical co -efficient
of perfectly elastic supply is infinity (PES = ). In this case, the supply
curve i s a horizontal straight line as in shown in figure 2.11(a). Such a
supply curve implies that with a small change in the price, the quantity
supplied will be infinite. Perfectly elastic supply is a theoretical extremity.
2. Perfectly Inelastic Supply
Supply is said to be perfectly inelastic when changes in price has a
zero impact or influence on the quantity supplied i.e. the quantity supplied
remains constant irrespective of the rise or fall in prices. Hence, the co -
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supply curve is a vertical straight line indicating constant supply as shown
in fig. 3.11(b). Perfectly inelastic supply is also a theoretical extremity.
3. Unitary Elastic Supply
When the change in quantity suppli ed is equal to the change in
price, supply is said to be unitary elastic. The numerical co -efficient of
unitary elastic supply is one (PES = 1). In this case, the supply curve is a
normal positive sloping one indicating proportionate or equal relationship
between price and quantity supplied as shown in figure 2.11(c).
4. Relatively Elastic Supply
When change in quantity supplied is greater than the change in
price, in percentage terms, supply is said to be relatively elastic. The
numerical value of relati vely elastic supply is greater than unity (PES > 1)
and the supply curve is gradually sloping upwards as shown in figure
2.11(d).
5.Relatively Inelastic Supply
When percentage change in the quantity supplied of a commodity
is less than the percentage cha nge in price, supply is said to be relatively
inelastic. The numerical co -efficient relatively inelastic supply is less than
one (PES < 1). In this case, the supply curve is steeply sloping upwards as
shown in fig. 2.11(e).
Fig.2.11 (a) Perfectly Elasti c Supply.munotes.in

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Fig.2.11 (b) Perfectly inelastic Supply.
Fig.2.11 (c) Unitary Elastic Supply.
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Fig.2.11 (e) Relatively inelastic Supply.
Price elasticity of supply, the coefficients of price elasticity of supply and
impact on supply is given in Table 2.6.
Table 2.6–PES, Coefficients of PES & Impact on Supply.
SNoPrice
Elasticity
of SupplyCoefficient
of PES Impact on Supply
1. Perfectly
elastic
supply.PES = αAt the given price, an infinitequantity is available for sale.However, with a small fall in the
price, the quantity supplied is zero.
The supply curve assumes a
horizontal slope.
2. Perfectly
Inelastic
Supply.PES = 0There is no change in the quantity
supplied irrespective of the changes
in price. Rise and fall in price haszero impact on the quantity supplied.The supply curve assumes a vertical
slope.
3. Relatively
Elastic
Supply.PES > 1 < αPercentage change in the quantity
sold by t he sellers is greater than
percentage change in price. The
supply curve assumes a flat slope.
4. Relatively
Inelastic
Supply.PES < 1 > 0Percentage change in the quantity
sold by the sellers is less than
percentage change in price. The
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5. Unitary
Elastic
Supply.PES = 1With a change in price, the sellers
make a proportionate change in the
quantity supplied. The supply curve
is drawn at 45oangle with a slope of
one.
2.11DETERMINANTS OF SUPPLY
The general dete rminants of supply are as follows:
1. Price of the Commodity. Ceteris paribus, higher the price of a
commodity, higher will be the quantity supplied of that
commodity. Supply and price are directly related to each other. A
higher quantity is supplied at a higher price because the marginal
cost of supplying a larger quantity increases and the total profits of
the supplier also increase. The seller is motivated by profits and
higher prices means higher profits to the seller.
2. Prices of related Commodities. Given the rise in the prices of
related goods, the supplier will shift his production from a low
price commodity to a high price commodity. Thus if prices of
plasma television sets rise due to change in consumer preferences,
the electronic goods produce r will produce more of plasma
television sets than the space consuming and less elegant looking
ordinary television sets. The demand for cars is ever increasing in
the Indian automobile market, particularly, in the small car
segment. The launch of TATA M otors’ ‘Nano’, the lowest price
small car has already induced other car manufacturers to also
launch their respective lowest priced small cars.
3. Prices of Factor Inputs. A rise in the price of a given factor input
will bring about a change in the relative prices of factor inputs such
as land, labor, capital and enterprise and will lead to a change in
the relative use of factor inputs. A producer will substitute more of
a factor whose price is relatively lower than the one whose price is
relatively higher. For instance, if labor prices are going up relative
to capital, a producer may shift to capital intensive lines of
production and hence the change in supply of different goods.
However, given the rise in the prices of factor inputs, the quantity
supplie d of a commodity will fall as the cost of production goes
up.
4. State of Technology. Technological change, innovations and
inventions brings about a change in the supply of various goods
and services. Technological changes reduce the amount of inputs
needed to produce a given quantity of output. The number of
automobiles produced on a given day in an automobile factory is
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On line banking services, helps the banks to reduce their
operational cost. The internet and electronic mail has replaced the
traditional method of written communication. The supply of letter
writing material such as plain paper, post cards, inland letters,
envelopes, telegraphic services etc has to fall as a result of cha nge
in technology. The cellular phone has become an ICE box because
it can be used for information, communication and entertainment
and hence has clearly replaced the traditional telephone instrument,
radio and the portable music player. The relative pric es of
electronic products have fallen due to rapid change in technology
and hence there has been a tremendous increase in t he supply of
electronic goods. Technological change, inventions and
innovations increases the use of the product and reduces the cos t
of production. From single use product to multiple use product
and from a high price product to a low price product is the result of
technological change, inventions and innovations.
5. Objective of the Firm. The supply of a commodity is influenced
bythe objective of the firm. If the objective of the firm is
maximizing sales, the firm may trade off some profits to achieve
larger sales and hence the supply would be higher than when profit
maximization is the objective.
6. Nature of the Market. If the ma rket is perfectly competitive, the
quantity supplied of a commodity will increase with more firms
joining the industry. Similarly, the quantity supplied will also
increase if the market is monopolistic. However, in oligopoly
markets, with the number of f irms more or less fixed, there may
not be any change in supply.
7. Government Policy. Taxes and subsidies influence the supply of
a commodity. While taxes increase the prices of the commodity in
the hands of a consumer, subsidies do the opposite. Impositi on of
an indirect tax such as sales tax and excise duty on domestically
produced goods will raise the price of a commodity and hence the
supply will fall. Conversely, reduction or elimination of custom
duties and other indirect taxes will lead to lower pr ices and
increase in the supply of goods and services. Further, subsidies
will increase the supply of a commodity because its price in the
hands of a consumer is reduced. Environmental and health issues
determine the kind of technology that will be used to produce
commodities. The government may impose rules to use
environmental friendly technologies and hence the cost of
production may go up. The government may either ban or may
make rules to adequately educate the consumers of tobacco and
tobacco rela ted products about the ill -effects of tobacco
consumption on health grounds. As a result, the supply of such
commodities would either vanish or fall due to lower consumer
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and hence the supply of goods may fall. A change in the trade
policy of the government would also influence supply. For
instance, if custom duties are either eliminated or reduced, the
supply will increase. After the adoption of the new economic
policy in 1991, the Governm ent of India has followed a free trade
policy and hence the variety and quantity of imports have
increased tremendously.
8. Other Factors. Other factors such as weather, market structure,
expectations about future prices, infrastructural facilities also aff ect
the supply of goods and services. Heavy rains may impede the
supply of farm products to cities. Poor infrastructure may increase
the supply time of a product. Monopoly markets will always
supply less than what is demanded and competitive markets wil l
always supply more than what is demanded. If suppliers expect
future prices to rise, they may reduce the present supply in
expectation of higher profits in future.
Check your progress:
1. State the Law of Supply.
2. Explain the exceptions to the Law of Supply.
3. Discuss increase and decrease in supply.
4. Discuss horizontal and vertical shift of supply curve.
5. Explain different types of elasticity of supply.
6. Mention various determinants of supply.
__________________________________________________ __________
____________________________________________________________
____________________________________________________________
____________________________________________________________
____________________________________________________________
2.12APPLICATIONS OF PED AND PES TO ECONOMIC
ISSUES
1. PRICE ELASTICITY OF DEMAND
Price elasticity of demand is the responsiveness of demand for a
commodity to the changes in its price. It is the ratio of percentage change
in quantity demanded to a percen tage change in price. Price elasticity of
demand (e p) can be stated as follows:munotes.in

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ep=Percentage change in quantity demanded
Percentage change in price
The co -efficient of price elasticity of demand can be derived with
the help of the following formula.
ep=Q
QP
P=Q
QP
P
=Q
OPP
Q=Q2-Q1
P2-P1P1
Q1
where Q = Original quantity demanded,
P= Original price,
Q= Change in quantity demanded (Q 2-Q1), and
P= Change in p rice (P 2-P1)
The price elasticity of demand is calculated without a minus sign
because of the obvious inverse relationship between price and quantity
demanded. It is therefore advised to ignore the negative sign either in the
numerator or the denominato r in the formula for price elasticity of
demand. The formula given above measures point price elasticity of
demand. The co -efficient of price elasticity denotes only small or marginal
changes. It thus measures elasticity at a point on the demand curve.
MEASUREMENT OF PRICE E LASTICITY OF DEMAND
(1)PERCENTAGE OF RATIO METHOD :Price elasticity of demand
according to this method can be measured by dividing the percentage
change in quantity demanded by percentage change in price. The
formula for percentage method can be stated as follows:
Price Elasticity of demand =
Percentage or proportional change in quantity demanded
Percentage or proportional change in price
Algebraically, the formula for price elasticity of demand can be
stated as follows:
ep=Q
QP
P=Q
QP
P
=Q
PP
Q=Q2-Q1
P2-P1P1
Q1
where Q= Original quantity demanded.
P= Original price.
Q= Change in quantity demanded (Q 2-Q1), and
P= Change in price (P 2-P2).
Let us solve some hypothetical problems and find out the price
elasticity of demand according to the percentage or ratio method. The
problems are given in exercise 1.munotes.in

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Exercise No. 1: Find the price elasticity of demand for the following
problem.
S.
No.Origina
lp r i c e
Rs./kgNew
price
Rs./kgOriginal quantity
demanded of Apples
per day (kgs)New quantity
demanded of
Apples perday (kgs)
1 100 15 100 70
2 100 12 80 60
3 100 80 50 60
Solution:
(1)In case of problem No. 1, the original price is Rs . 100 per kg of
apples and the original quantity demanded is 150 kgs. When the price
rises to Rs. 150 per kg, the quantity demanded falls to 70 kilo -gram.
ep=Q
PP
Q
=Q2-Q1
P2-P1P1
Q1
Substituting the values f or Q 1Q2and P 1P2,w eg e t
=70-100
100-100100
100
i.e.30
50100
100=3
5= 0.6
ep= 0.6
The price elasticity of demand is 0.6. Hence demand is
relatively inelastic (e p< 1). In this case, the percentage change in quantity
demanded is less than the percentage change in price. You will notice that
while the price rose by 50%, the demand fell only by 30%.
(2)In case of problem No. 2, the data pertaining to price and quantity is as
follows:
P1= 100, P2= 120
Q1= 80, Q2= 60
By substituting the value of P 1P2and Q 1Q2,w eg e t ,
60-80
120-100100
80
20
20100
80=5
4= 1.25
Then the co -efficient of price elasticity of demand is 1.25. In
this case, percenta ge change in quantity demanded is greater than
percentage change in price. Hence, the price elasticity of demand ismunotes.in

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greater than one (e p>1). The percentage fall in quantity demanded is 25
percent and the percentage rise in price is 20 percent.
(3)In case of problem No. 3, the data pertaining to price and quantity is as
follows:
P1= 100 P2= 80
Q1= 50 Q2= 60
Substituting the values of P 1P2and Q 1Q2we get,
60-50
80-100100
50=10
20100
50=5
5=1
In this case ,t h ec o -efficient of price elasticity of demand is one or
unity i.e., demand is unitary elastic. Demand is said to be unitary elastic
where percentage change in quantity demanded is equal to percentage
change in price. Hence, the percentage rise in quanti ty demand is 20
percent and the percentage fall in price is also 20 percent.
(2)ARCMETHOD .The Arc method is used to measure price elasticity of
demand when the changes in the price and quantity are substantially
large and not infinitesimally small as in t he case of measuring
elasticity of demand at a point on the demand curve. The Arc method
uses the average of the changes in the price and quantity demanded.
The average price can be found by dividing the sum of the two prices
by two i.e.,P1+P 2
2and the average quantity can be found by dividing
the sum of the quantities by two i.e.Q1+Q 2
2The Arc elasticity
formula can therefore be stated as follows:
ep=Q
Q1+Q 2
2P
P1+P 2
2
=Q
Q1+Q 2P1+P 2
P
=Q
PP1+P 2
Q1+Q 2
Let us solve a numerical example by using the Arc method to find
out the price elasticity of demand.
Example:
Price
(Rs.)Quantity
Demanded (kgs)
P1 5.00 Q1 250
P2 10.00 Q2 150munotes.in

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Let us state the Arc elasticity formula;
ep=Q
Q1+Q 2
2P
P1+P 2
2
Here, Q= 250 -150 = 100
P= 10 -5=5
Average price =10 + 5
2= 7.5
Average quantity =250 + 150
2= 200
Substitut ing the value Q,P, Average Price (AP) and average
quantity (AQ), we get
ep=100
2005
7.5
=100
2007.5
5=1
27.5
5=7.5
10= 0.75
Thus the price elasticity of demand is equal to 0.75 i.e. e p< 1.
Alternatively, the co -efficient of price elasticity by the Arc method
can be found by the formula.
ep=Q
PP1+P 2
Q1+Q2
By substituting the same values in the above formula, we get
ep=100
55 + 10
250 + 150
=100
5150
400
=3
4= 0.75 (ep<1)
2. CROSS ELASTICITY OF DEMAND
Cross price elasticity of demand deals with impact of change in the price
of one commodity, say commodity ‘x’ on the quantity demanded of
commodity ‘y’, where t hese goods are either complementary or substitute
goods. The formula for cross price elasticity of demand can be stated as
follows:
exy=Percentage change in the quantity demanded of commodity 'x'
Percentage change in the price of commodity 'y'
i.e. e xy=Qx
Qx100
Py
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=Qx
QxPy
Py
=Qx
QxPy
Py
=Qx
PyPy
Qx
where, e xystands for cross price elasticity of demand of commodity ‘x’
in relation to the pri ce ‘y’.
Qx= Original quantity demanded of commodity ‘x’.
Qx= Change in the quantity demanded of commodity ‘x’ i.e. (Q 2–
Q1).
Py= Original price of commodity ‘y’.
Py= Change in the price of commodity ‘y’ i.e. (P 2–P1)
In case of substitute goo ds, the cross price elasticity of demand is
positive. For instance, a rise in the price of mutton will lead to a rise in the
demand for beef, price of beef remaining constant. A rise in the price of
coffee will lead to rise in the demand for tea, price of tea remaining
constant. A rise in the price of rice will lead to rise in the demand for
wheat. In all these examples, the goods under consideration are
substitutes. The demand for tea, beef and wheat rises because these goods
have become relatively cheaper and mutton, coffee and rice have become
relatively dearer or expensive. Before the rise in price, some of the people
who consumed mutton, coffee and rice will now consume beef, tea and
wheat. As a result, the demand for mutton, coffee and rice will fall a nd
that of the demand for beef, tea and wheat will rise.
In the case of complementary or jointly demanded goods, the
change in the quantity demanded of either of the goods takes place in the
same direction. For instance, tea and sugar, cas sette players and audio
cassettes, car and petrol are all complementary goods. If the price of audio
cassettes go up, the demand for both audio cassettes and cassette players
will fall. Similarly, if the price of sugar in the Indian context goes up, the
demand for tea as well as sugar will fall. Or if the price of petrol goes up
substantially, the demand for cars as well as petrol will fall.
Complementary goods thus, have negative cross price elasticity of
demand.
The coefficient of cross p rice elasticity of demand varies from
(+1) in case of perfect substitutes to ( –1) in case of perfect complements.
For example, fountain pen and ink are perfect complements, whereas
fountain pen and ball point pen are perfect substitutes.
Letus find out the cross price elasticity of demand by solving the
following problems.munotes.in

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(1)Let us assume that the original price of beef per kg is Rs. 50/ –and the
quantity demanded is 200 kgs. per day. Let us also assume that the
price of mutton is Rs. 100/ –perkg and the quantity demanded is 100
kgs. per day. Now when the price of mutton rises to Rs. 120/ –per kg.,
the quantity demanded falls to 80 kgs. per day and the price of beef
remaining constant, the quantity demanded rises to 220 kgs. per day.
Now let be ef be commodity ‘x’ and mutton be commodity ‘y’.
Here, Px1= Rs. 50/ –per kg.
Qx1= 200 kgs/day.
Py1= Rs. 100/ –per kg.
Qy1= 100 kgs/day.
when Py2= Rs. 120/ –per kg.
Qy2= 80 kgs/day.
with Pxremaining constant.
Qx2= 220 kgs/day.
Let us state th e formula for cross price elasticity of demand.
exy=Qx
PyPy
Qx
Now let us substitute the given values in the above formula.
exy=Qx2–Qx1
Py2–Py1Py1
Qx1
=220–200
120–100100
200
=20
20100
200=1
2= 0.5
Thus, the coefficient of cross price elasticity of demand for
beef is positive but less than one. Here e xy= 0.5. Thus when the price of
commodity ‘y’ i.e. mutton, increased by 20 percent, the quantity
demande d of beef increased only by 10 percent i.e., the quantity demanded
of commodity ‘x’ increased to the extent of 50 percent of the change in the
price of commodity ‘y’.
Alternatively,
exy=%Qx
%Py=10%
20%= 0.5
Hence (e xy= 0.5)
In the Indian market, mutton and beef are not perfect substitutes
and hence the cross price elasticity of demand for beef is positive but less
than one.munotes.in

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(2)Let us find the cross price elasticity of demand in case of
complementary goods such as tea an d sugar in the India context. Let
tea be commodity ‘x’ and sugar be commodity ‘y’ and let us assume
the price quantity relationship to be as follows:
The original price of sugar is Rs. 15/ –per kg and the original
quantity demanded is 100 kgs of sugar per day. The original price of tea is
Rs. 200/ –per kg and the original quantity demanded is 100 kgs per day.
Now when the price of sugar rises to Rs. 30/ –per kg, the quantity
demanded of sugar falls to 50 kgs per day. However, the price of t ea
remaining constant at Rs. 200/ –per kg, the quantity demanded falls to 50
kgs per day. Now let tea be commodity ‘x’ and sugar be commodity ‘y’.
Here, Px1= Rs. 200/ –per kg
Qx1= 100 kgs per day.
Py1= Rs. 15/ –per kg.
Qy1= 100 kgs/day.
when, Py2=Rs. 30/ –per kg.
Qy2= 50 kgs per day.
However,P xremaining constant at Rs. 200/ –per kg, the quantity
demanded of tea in Q x2is only 50 kgs per day.
Let us state the formula for cross price elasticity of demand.
exy=Qx
PyPy
Qx
Now let us substitute the given values in the above formula:
exy=Qx2–Qx1
Py2–Py1Py1
Qx1
=50–100
30–1515
100
=–50
1515
100=–50
100=–0.5
Thus the coefficient for cross price elast icity of demand for tea is negative
(exy=–0.5)
Thus we see that when price of sugar rises from Rs. 15/ –to Rs.
30/–per kg, the demand for sugar as well as tea falls, although there is no
change in the price of tea. Therefore, cross price elasticity of demand in
case of complementary goods is negative. In our example; a hundred
percent rise in the price of sugar has resulted in a fifty percent fall in the
demand for both the goods ‘x’ and ‘y’.munotes.in

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ox
QuantityDemanded
(Beef)D1
D1(e>0)xyPRICE(Sugar)y
ox
QuantityDemanded
(Tea)D2
D2(e<0)xyPRICE(Ice-cream)y
oxQuantityDemanded(Tea)D3
D3(e=0)xy
Fig.2.12 Cross Price Elas ticity of Demand
The cross price elasticity of demand in case of unrelated goods is
equal to zero. It means that changes in the price of commodity ‘y’ will
have no effect on the quantity demand of commodity ‘x’, both goods
being unrelated. For instance, changes in the price of ice -cream will have
no effect on the quantity demanded of tea. Thus when the impact on the
quantity demanded of tea is zero, the cross price elasticity of demand is
zero (e xy= 0). The cross price elasticity of demand is diagramma tically
represented in fig. 2.12 (a), (b) and (c) for substitutes, complementary and
unrelated goods.munotes.in

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3. INCOME ELASTICITY OF DEMAND
Prices of the goods and services and the income of the consumer
are the two most important objective factors that determin e demand.
Unlike prices, the relationship between quantity demanded and the level of
income is direct and therefore. If we were to plot an income demand
schedule, we will obtain an upward sloping or a positive sloping income
demand curve. This positive rel ationship between income and demand can
be algebraically expressed as under:
Qdx
Y>0
A simple income demand function can be stated as Qdx = f(Y)
when Qdx = quantity demanded of commodity ‘x’
Y= level of income.
It means, other demand determinants remaining constant, when
income rises, quantity demanded also rises and when income falls quantity
demand also falls. Income elasticity of demand measures the extent of rise
or fall in demand as a result of change in income. The co -efficient of
income elasticity of demand can be measured as follows:
ey=Percentage change in the quantity demanded
Percentage change in income
Symbolically e y=Q
QY
Y=Q
YY
Q
Where Q= Change in the quantity demand ed.
Y= Change in income.
Q= Original demand.
Y= Original income.
Alternatively, the income elasticity formula can be restated as:
ey=%Q
%Y
where % Q refers to percentage change in the quantity demanded, and
%Y refers to percent age change in income.
Here % Q can be obtained as
Q2–Q1
Q1100, and
%Y can be obtained as:
Y2–Y1
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Thus e y=Q2–Q1
Q1100
Y2–Y1
Y1100=Q
Q1
Y
Y1=Q
YY1
Q1
Let us take a numerical example and find out the income elasticity of
demand.
Example 1:
Suppose a consumer’s income is Rs. 5,000 per month and he
purchases 5 kgs of Basmati rise per month. Now when his income rises to
Rs. 6,000 per mo nth, the quantity demanded of basmati rises to 7 kgs per
month. The income elasticity of demand can be found as follows:
Let us state the formula for income elasticity of demand:
Q
YY1
Q1
In the given illustration,
Y1= Rs. 5,000 and Q1= 5 kgs.
Y2= Rs. 6,000 and Q 2= 7 kgs.
Substituting these values in the given formula, we get:
7–5
6‚000 –5‚0005‚000
5
2
1‚0005‚000
5=10
5=2
ey=2
The coefficient of income elasticity of deman d is equal to 2 which
indicate that the rise in demand for basmati rice is twice as much as the
rise in income. In our example, while the income increased only by 20
percent, the demand for basmati rice rose by 40 percent. Using the
formula:
ey=%Q
%Y
we get e y=40 %
20%=2
Check your progress:
1. What are the methods of measurement of Elasticity of demand?
2. Discuss Cross elasticity of demand.
3. Explain Income elasticity of demand.
__________________________________________ __________________
____________________________________________________________
____________________________________________________________
____________________________________________________________
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2.13 ESTIMATION OF DEMAN D: PROBLEMS AND
APPLICATIONS.
Problem 1:
A telephone instrument manufacturing firm hires the services of an
economist to determine the demand for the cordless instruments
manufactured by it. The demand for the cordless instrum ents (Qx) is given
in the form of the equation:
Qx= 12000 -5000 Px + 5 I + 500 Pc
where Px= Price of cordless phones.
I= Income per capita.
Pc= Price of substitute cordless phones manufactured by the
competitors.
With this information, the fi rm wants to determine:
(1)The effect of a price increase on the total revenue.
(2)How sale of cordless phones would increase during a period of rising
income.
(3)The probable impact, if competitors raise their prices.
The initial values of,
Px= $5, I = $10,000 an d Pc = $6.
Solution:
(1)The effect of a price increase can be assessed by computing the point
price elasticity of demand.
Substituting initial values:
Qx= 12000 + 5(10,000) + 500(6) + 5000 Px
Qx= 65000 -5000 Px
i.e. 65000 -5000(5) = 40,000.
At Px = $ 5, quantity demanded of cordless phones is 40,000 units.
Using this data, the point price elasticity is:
ep=–5000 5
40‚000=–0.625
Demand is therefore inelastic. Hence, raising the price would
increase total revenue.
(2)The income elasticit y determines whether a product is a necessity or a
luxury. From the demand equation, the derivative
dQx
dI=5
Thus income elasticity is:
em=510‚000
40‚000= 1.25munotes.in

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Thus, em>1. The cordless phones are therefore perceived by th e
consumers as a luxury good. Thus as income increases, sales would
increase more than proportionately.
The demand equation implies that:
dQx
dPc= 500
Thus the cross price elasticity of demand (cxy) is positive.
cxy= 500 6.00
40‚000= 0.075
Hence a one percent increase in prices of other cordless phones
would result in a 0.075 percent increase in demand for the phones
manufactured by the firm under consideration.
Problem 2:
Everest Poultry Farm hires the services of an econo mist to determine
the demand for eggs. The professional economist takes that the weekly
demand for eggs will be the function of the following:
(a)Price of eggs.
(b)Consumer’s annual aggregate income.
(c)Price of potatoes.
The demand for eggs (Q E) is given in the f orm of the following equation:
QE= 10,000 -500 P E+ 100 I + 50 P P…(1)
Where,
QE= Quantity of eggs demanded per week in dozens.
PE= Price of eggs in Rupees per dozen.
I= Income of consumers in Rupees -crores per annum.
PP= Price of potatoes per kil ogram.
The demand equation given at (1) above reveals the following:
(a)The weekly demand for eggs is a function of price of eggs, consumers’
aggregate income and the price of potatoes.
(b)A one rupee rise in the price of eggs results in a fall in demand for
eggs by 500 Dozens per week.
(c)An increase of Rs. one crore in the annual income of the consumers
results in increase in demand by 100 dozens per week.
(d)A one rupee increase in the price of potatoes increases demand for
eggs by 50 Dozens per week.
The initial v alues of:
I= Rs. 100 crores.
PP= Rs. 10 per kilogram.munotes.in

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Questions
(1)Draw a demand curve based on the demand equation.
(2)What will be the demand for eggs at various prices such as Rs. 40, Rs.
30, Rs. 20 and Rs. 10 per dozen?
(3)What will be the demand equation if the aggregate income of the
consumers rises to Rs. 110 crores and the price of potatoes rises to Rs.
12 per kg.? Graphically show the shift in the demand curve as a result
of changes in the values of ‘I’ and ‘P P’.
(4)What will be the demand equation if the p rice of potatoes goes up by
Re. 1 with all other values remaining constant as in the original
equation? Also state the quantity demanded of eggs when potatoes are
sold at Rs. 11 per kg and eggs at Rs. 20 per dozen.
(5)Price of potatoes remaining constant at R s. 10 per kg. and those of
eggs at Rs. 20 per dozen, what will be the impact on the demand for
eggs, if the aggregate income rises to Rs. 110 crores per annum?
Solution:
(1)Substituting the initial values of ‘I’ and ‘P P’ in equation (1), we get:
QE= 10,000 -500 (P E) + 100(100) + 50(10)
QE= 10,000 + 100(100) + 50(10) + 500 P E
QE= 10,000 + 10,000 + 500 + 500 P E
QE= 20,500 -500 P E… (2)
The demand equation at (2) above can be graphically shown as in
figure 5.1 below.
Q= 2 0 , 5 0 0 - 5 0 0 PE E
Q= 2 1 , 6 0 0 - 5 0 0 PEEQty demandedA1
A
O BB1PRICEOFEGGS(Rs.perDOZ)
of Eggs (Dozs for week)
Demand Curve and Shift in the Demand Curve
Point ‘A’ on the Y -axis in Fig. 1 reveals that when price of eggs is
OA per dozen, the quantity demanded of eggs is zero dozens per week
i.e., when price of eggs is Rs. 41 per dozen the quantity demanded ismunotes.in

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zero. (20,500 500 = P Ei.e., Rs. 41). Similarly, when price of eggs is
Rs. zero per dozen, the quantity demanded is 20,500 dozens per week.
Between the two extreme ends of the demand curve AB, we have a
series of points expressing the price -quantity rel ationship of eggs.
(2)The demand for eggs at various prices such as Rs. 40, 30, 20, 10 and
Zero can be obtained as below:
(a)At Rs. 40 per dozen, the demand for eggs will be:
QDE= 20,500 -500(40) = 500 Dozen per week.
(b)At Rs. 30 per dozen,
QDE= 20,500 -500(30) = 5500 Dozens per week.
(c)At Rs. 20 per dozen,
QDE= 20,500 -500(20) = 10,500 Dozens per week.
(d)At Rs. 10 per dozen,
QDE= 20,500 -500(10) = 15,500 Dozen per week and
(e)At Rs. zero per dozen the demand for will be:
QDE= 20,500 -500(0) = 20,500 doz ens per week.
Note: The slope of the demand curve with reference to the
price axis is -500.
(3)If the aggregate income of the consumer rises to Rs. 110 crores per
annum and price of potatoes goes up to Rs. 12 per kg. the demand
equation will be as follows:
QE= 10,000 + 100(110) + 50(12) + 500 P E
QE= 10,000 + 11,000 + 600 + 500 P E
QE= 21,600 -500 P E
As a result, at the changes in the values of ‘I’ and ‘P P’, the demand
curve will shift towards the right i.e., more of eggs will be demanded
per week at the given prices. In Fig. 1 above, you will notice the
demand curve AB have shifted towards the right to become A 1B1. The
demand equation Q E=21600 -500 P Eshows that at Rs. 43.20 per
dozen, the quantity demanded at eggs per week will be zero and at R s.
zero per dozen, the quantity demanded will be 21,600 dozen per
week.
(4)If the price of potatoes goes up by Rs. one with all other values
remaining constant, the quantity demanded of eggs per week will rise
by 50 dozens. This can be obtained as follows:
QE= 10,000 + 100(100) + 50(11) + 500 P E
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Now let us find out the quantity demanded of eggs at Rs. 40 per
dozen.
QE20,550 -500(40) = 550
Refer answer to question number two. When the price of potato was
Rs. 10 per kg., the dema nd for eggs was 500 dozen per week. Thus
one rupee rise in the price of potatoes results in the rise in demand for
eggs by 50 dozens per week (550 -500).
(5)If the aggregate income of the consumer goes up from Rs. 100 crores
to Rs. 110. crores per annum, wi th all other values remaining
constant, the quality demanded of eggs per week at Rs. 20 per dozen
will be as follows:
QE= 10,000 + 100(110) + 50(10) + 500 P E
QE= 21,500 -500 P E
At Rs. 20 per dozen, the quantity demanded of eggs per week will
be:
QE= 21,500 -500(20) = 11,500
Note that when the aggregate income was Rs. 100 crores, the quantity
demanded was 10,500 dozens per week at Rs. 20 per dozen. A one
per cent rise in income would result in risk in demand for eggs by 100
dozens. Thus a 10 perc ent rise in income would result in rise in
demand for eggs by 100 dozens (11,500 -10,500). (Refer 2 (c)).
Problem 3:
Oriental Refrigerated Meat Products hires the services of an
economist to determine the demand for mutton per week. The economist
states that the demand for mutton will be the formation of the following:
(a)Price of mutton per kg.
(b)Consumer’s annual aggregate income.
(c)Price of chicken per kilogram.
The economist stated the demand for mutton in the form of the
following equation:
QM= 20,0 00-100 P M+ 100 I + 100 P C
Where,
QM=Quantity demanded of mutton in kilogram per week.
PM= Price of mutton in rupees per kg.
I= Aggregate Income of the consumers in rupees crores per
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The initi al values of ‘I’ and ‘P C’ are Rs. 100 crores and Rs. 100 per
kilogram.
Questions:
(1)Draw a demand curve based on the demand equation: Q M= 20,000 –
100 P M+ 100 I + 100 P Cand state at what prices the quantity
demanded of mutton will be zero and maximum.
(2)What will be the demand for mutton at various prices such as
Rs. 300, Rs. 200 and Rs. 100 per kilogram?
(3)What will be the impact on demand for mutton, if the aggregate
income of the consumers rises by 10 percent? Graphically show the
shift in the demand curv e along with the demand equation.
(4)If the price of chicken goes up by 10 percent, what will be the impact
on the demand for mutton with price of mutton being Rs. 100 per kg.
and the aggregate income being Rs. 110 crores.
(5)If the price of chicken falls by 10 percent with other values as in
question number ‘4’, what will be the impact on the demand for
mutton. Also show the shift in the demand curve for mutton as a
result of the rise in price of chicken.
Problem 4:
General Electrical Appliances Pvt. Ltd. hi res an economist to
determine the demand for toasters which it is planning to launch in the
immediate future. The demand for toasters (Q T) is given in the form of the
following equation:
QT= 15,000 -1000 P T+ 100 I + 100 P C
Where,
QT= the demand for e lectrical toasters
PT= Price of electrical toasters
I= Income per capita per annum
PC=Price of substitute electric toasters manufactured by the
competitors.
The initial values of:
PT= Rs. 175
I= Rs. 20,000
PC= Rs. 200
Questions:
(1)The demand f or electric toasters at the given price of Rs. 175 per
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(2)The point price elasticity of demand for electronic toasters of Rs. 175
per piece.
(3)If the per capita income (PCI) of the community rises by 10 percent,
what will be the impact on the demand for toasters?
(4)At the given price of Rs. 175 per piece and PCI of Rs. 20,000, what is
the income elasticity of demand?
(5)What will be the impact on demand for toasters if the price of the
substitute goes up by 10 percent?
(6)What will be the cross price elasticity o f demand for the electric
toasters when the price of substitute is Rs. 210 per piece?
(7)Draw a demand curve on the basis of the initial equation and show the
shift in the demand curve when the PCI rises.
2.14MEASUREMENT OF ELASTICITY OF SUPPLY
The price e lasticity of supply can be measured with the ratio
method as shown in Figure 2.13. The price elasticity of supply at a point
on the supply curve can be measured as follows:
PES =Q
QP
P=Q
QP
P
=Q
OPP
Q=Q2-Q1
P2-P1P1
Q1
Where ∆Q/∆P is the slope of the supply curve S1which is OB/BP
and P/Q is equal to BP/OB. The elasticity of supply at point ‘P’ on the
supply curve S 1is OB/BP × BP/OB = 1 or Unity. The elasticity of supply
at point ‘P’ is equal to one (PES = 1). On the supply curve S 2, the
elasticity of supply at the same point ‘P’ is AB/BP × BP/OB =AB/OB < 1
or PES < 1. On supply curve S 3, the elasticity of supply at point ‘P’ is
A1B/BP × BP/OB = A 1B/OB > 1 (PES > 1).
It is clear that the price elasticity of supply on a given point on the
supply curve depends upon the slope of the supply curve. Note that the
supply curve S 3has a relatively flatter slope, thereby showing relatively
elastic supply. Recall that when supply is relatively elastic, percentage
change in the quantity supplied is greater than the percentage change in
price. Symbolically, the price elasticity of supply at point ‘P’ on supply
curve S3 can be stated as follows:
PES at point ‘P’ on S 3=%∆ Q>1
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S2 has a steeper slope and hence shows relatively inelastic supply.
Symbolically, the price elasticity of supply at point ‘P’ on S 2can be stated
as follows:
PES at point ‘P’ on S 2=%∆ Q <1
%∆ P
S1has a constant slop e with unitary elastic supply. The price
elasticity of supply at point ‘P’ on the supply curve S 1is equal to one.
Symbolically, it can be stated as follows:
PES at point ‘P’ on S 1=%∆ Q=1
%∆ P
Fig.2.13–Measurement of Price Ela sticity of Supply.
2.15 PARADOX OF BUMPER HARVEST
In India, vegetable prices of onions and tomatoes have widely
fluctuated between crop failures and bumper harvests. The demand for
onions and tomatoes is relatively inelastic. If the onion or tomato cr op
failures, there will be a shortage in the market and the hence the market
prices will go up substantially. In the last two decades, it has been found
that onion prices have gone up from Rs.2/ -per kilogram in the 1990s to
Rs.100 per kg in the 2011s. The same has been true of the prices of
tomatoes.
The output of tomatoes and onions may go up due to good rains or
due to better and improved methods of farming and farm technology.
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cropping pattern, there will be excess output and prices will fall. The
farmer thinks that if the output is more, he or she will get more revenue.
However, the demand for onions and tomatoes being inelastic, in times of
a bumper harvest, the prices of these vegetables fall sharply than the rise
in demand leading to a fall in revenue. Thus the farmers are poorer with a
bumper harvest and richer with a poor harvest. The fall in revenue due to
a bumper harvest is shown in the figure 2.14.
Fig.2.14–The Par adox of a Bumper Harvest of Tomatoes.
At Rs.30/ -per kg, the quantity demanded and supplied of tomatoes
is 100 kg. When a good monsoon is predicted, farmers in India should go
for a diversified crop and reduce the cropped area of tomatoes or onions
becau se a bumper crop of onions and tomatoes or for that matter any other
crop would bring down the prices. However, due to want of knowledge,
the farmers decide to sow the available land with the tomato crop in the
hope that they would sell the crop at the sa me price of Rs.30/ -and earn a
proportionately larger revenue. As a result of the bumper crop, the supply
curve of tomatoes shifts to the right i.e. from S 0to S 1. At the price of
Rs.30/ -per kg, there is an excess supply of tomatoes equal to 80 kg.
Excess supply pushes down the price to Rs.20/ -per kg as the original
demand curve intersects the new supply curve at point E 1. Accordingly,
120 kg of tomatoes is the new demand. The farmers end up earning only
Rs.2400/ -at the new lower price as compared t o Rs.3000/ -when the price
was Rs.30/ -per kg.
The above example illustrates that when the demand is relatively
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earn larger revenue. Instead, the farmers with a bigger harvest h ave ended
up becoming poorer by Rs.600/ -. The situation is paradoxical because
ordinarily with a bigger output, the revenue should be higher. However,
in the case of tomatoes, a bigger output has yielded lower revenue.
Can we neutralize the paradox of Bumper Harvest?
The paradox of bumper harvest need not be true if the farmers
either individually or collectively set up cold storage facilities. With the
cold storage facilities in place, the farmers can go for a bumper harvest
and still earn larger re venue. Cold storage facilities will allow the farmers
to create a stock of tomatoes and supply them to the market according to
the market conditions. Organizationally, the farmers can establish their
co-operatives and become entrepreneurs rather than bei ng mere peasants.
2.16TAX ON PRICE AND QUANTITY
Tax is a fundamental source of revenue to the government. Any
government will impose taxes on goods and services (indirect taxes) to
generate revenue. Government may impose an indirect tax on the buyer s
or on the sellers. If a tax is imposed on the buyers, the demand curve will
shift to the left. Similarly, if a tax is imposed on the sellers, the supply
curve will shift to the left. When a tax is imposed either on the buyer or
the seller, the burden of tax is shared by both the buyers and the sellers.
The proportion of tax burden shared depends upon elasticity of demand
and supply.
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2.17IMPACT OF TAX IMPOSED ON BUYERS
Let us look at the impact of a tax imposed on the buyers. Suppose
the Government of Maharashtra imposes a sales tax of Rs.5/ -on 250 ml
soft drink bottle on the buyers. Since the tax is imposed on the buyers, the
supply curve will remain constant. The buyers now will have to pay
Rs.5/ -more ever y bottle of soft drink. The demand for soft drinks will fall
and as a result the demand curve will shift to the left by the extent of the
tax as shown in Figure. Assuming the market price of a 250 ml soft drink
bottle is Rs.10/ -, the buyers will have to pay Rs.12/ -due to the new tax. In
order to make up for the effect of the tax, the market price must be lower
by Rs.5/ -. The new market price is Rs.8/ -and the equilibrium quantity of
soft drinks falls from 100 to 90 bottles. The sellers will now sell le ss and
the buyers will also buy less as per the new equilibrium. The tax on soft
drinks will therefore reduce the market size of soft drinks. However, the
burden or the incidence of tax will be shared by both the buyers and the
sellers. Since the market price of soft drink bottles come down by Rs.2/ -,
the sellers will receive Rs.2/ -less for every bottle of soft drink sold and
the buyers will pay Rs.3/ -more and the soft drink bottle will now be sold
for Rs.13/ -i.e. Rs.8 + Rs.5 = Rs.13/ -. A tax on the buyer makes both the
buyers as well as the sellers worse off due to elastic demand.
To conclude, it can be said that taxes discourage market activity.
When a commodity is taxed, the quantity of the commodity sold in the
new equilibrium is lesser. The bu rden of tax is shared by the buyers as
well as the sellers. In this case, the buyers share a larger burden because
the supply curve is less elastic.
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2.18IMPACT OF TAX ON SELLERS
When a tax of Rs.5/ -is impose d on the sellers of soft drinks, the
profitability of selling soft drinks falls and hence the supply curve shifts
upward or to the left. Given the market price of soft drink to be Rs.10/ -
per 250 ml bottle, the seller will receive only Rs.5/ -per bottle a fter
providing for the tax. In order to induce the sellers to supply the same
quantity of soft drink bottles, the market price must be Rs.15/ -. The
supply curve shifts upward from S 1to S 2by the size of the tax (Rs.5/ -).
The figure shows that the equil ibrium price of soft drinks rises from Rs.10
to Rs.13 and the equilibrium quantity falls from 100 to 90 soft drink
bottles. Irrespective of on whom the tax is imposed, the size of the soft
drink market is reduced. Since the market price rises, the buyers pay
Rs.3/ -more for each bottle of the soft drink. Sellers receive a higher price
of Rs.13/ -but the effective price after tax comes to Rs.8/ -per bottle.
2.19MAXIMUM PRICE CEILING
Governments intervene in the market by fixing maximum prices.
During i nflationary periods, the government may impose wage and price
controls to arrest the spiraling prices. When a price ceiling is imposed, the
maximum price of a product or a service is prescribed by the government.
Price ceilings can be binding and non -binding. A binding price ceiling is
imposed below the equilibrium price whereas a non -binding price ceiling
is imposed above the equilibrium price.
Effect of Price Ceiling on the Market
Price ceiling places a legal maximum on prices. A price ceiling
will benon-binding on the sellers if the equilibrium price is below the
price ceiling as shown in the following figure. For example, the
Government imposes a price ceiling of Rs.25/ -per kg of sugar during the
festival season. In this figure, the price dete rmined by the market forces is
Rs.20/ -per kg and the price ceiling imposed by the Government is Rs.25.
Such a price ceiling will not influence market price. However, the market
price cannot go above Rs.25 per kg of sugar.
When the government imposes a p rice ceiling that is below the
market price, it is called a binding price ceiling. In this case, the market
price cannot rise above the price ceiling. In such a situation, the market
demand will be greater than market supply and there will be shortage of
sugar. This can be seen in Figure. Since the market price of Rs.20 per kg
of sugar is above the price ceiling of Rs.15, the quantity supplied by the
market is only 80 quintals of sugar whereas the market demand is 120
quintals of sugar. There is a shor tage of 40 quintals. Forced shortages
lead to rationing of the commodity. The rationing mechanism that
develops under a binding price ceiling is not undesirable and unfair
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will have t o stand in long queues to buy the goods and those who actually
need sugar may not get sugar, thereby making the markets less efficient.
The free market mechanism is much more efficient because at the
equilibrium price, sugar will be available to all those who can pay the
equilibrium price.
Figure 2.17-Effect of Price Ceiling above the Market Price.
Figure 2.18-Effect of Price Ceiling below the Market Price.munotes.in

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2.20PRICE FLOORS AND MARKET OUTCOMES
Price floors place a legal minimum on the pri ces. Price floor may
be classified into binding and non -binding price floors. When the
government imposes a price floor which is above the equilibrium price, it
is a binding price floor whereas a price floor imposed below the
equilibrium price is a non -binding price floor. This is shown in Figures
3.19 and 3.20. In the case of a non -binding price floor, the equilibrium
price is determined by the market forces and stays above the price floor.
The price floor of Rs.15 per kg of sugar has no impact whats oever on the
equilibrium price of Rs.20 per kg of sugar. However, under no
circumstances, the price can fall below the price floor. In India, the
Committee on Agricultural Costs and Prices determine the minimum
support prices of a number of agricultural goods such as wheat, jowar,
bajra, chana, pulses, cotton, de -husked coconut, copra etc. These support
prices ensure that the market price will not fall below the MSP of these
goods. For instance, in 2015 -16, the MSP of Wheat was Rs.1525 per
quintal i.e. Rs.15.25 per kg. The market price of wheat in the commodity
exchange market was Rs.1748 per quintal i.e. Rs.17.48 per kg.
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Figure 2.20-Price Floor above the Market Price (Binding) .
When the price floor is set above the equilibrium market price as shown in
Figure. 2.20, the price floor is binding on the market. As a result, there is a
surplus of 40 quintals of sugar. Sellers willing to sell sugar at Rs.25/ -per
kg are unable to se ll because there are no buyers for the surplus quantity of
40 quintals. A binding floor price therefore causes a surplus.
Price ceilings below the market price create shortages and price
floor above the market prices creates surpluses. Price ceilings w hich are
binding in nature i.e. set below the market prices create shortages and lead
to rationing mechanism. Similarly, price floors above the market prices
are binding in nature and create surpluses. Market mechanism is held
hostage by such government interventions. Both production efficiency
and allocation efficiency is not achieved on account of price ceilings and
price floors.
2.21THE MINIMUM WAGE CONTROVERSY
Minimum wage is an example of a binding price floor which is set
above the equilibrium market wage rate. The Government of India has
passed the Minimum Wages Act of 1948. Accordingly, minimum wages
are set and revised periodically for a number of industrial and non -
industrial trades. For reference, the minimum wages for a few trades in
Maharashtra for the period January 2020 to July 2020 are given in the
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If the minimum wages are set above the market wage rates, there
will be unemployment. In the absence of government intervention, the
market forces will determine the equilibrium wage ra te. Both the
situations are shown in Figures 2.21 and 2.22. In Figure 2.21, the labor
market clears at OW wage rate and ON level of equilibrium employment.
However, when the government intervenes and set the minimum wage rate
above the market determined wage rate, there will be disequilibrium in the
labor market leading to surplus labor or unemployment. Figure 2.21 show
that at the minimum wage rate fixed by the government, the market
demand for labor is ON 2whereas the market supply of labor ON 3.
Gover nment intervention creates unemployment in the labor market by
N2N3. However, if the minimum wages set by the government in various
trades is below the market determined wage rate, they will have no
influence on the equilibrium wage rate and hence any une mployment in
the economy will not be attributed to the fixing of minimum wages.Table 2.6-Minimum Wages in Maharashtra (Zone -I) for the period
January 2020 to July 2020
Employment Minimum wages
(in INR)
Automobile Repairing
1.Skilled 11044.0 0
2.Semi -skilled 10644.00
3.Unskilled 10344.00
Bakeries
1.Skilled 12778.00
2.Semi -skilled 11878.00
3.Unskilled 10928.00
Hair cutting Saloon
1.Skilled 12236.00
2.Semi -skilled 11536.00
3.Unskilled 11036.00
Readymade Garments
1.Skilled 13298.00
2.Semi -skilled 12598.00
3.Unskilled 12098.00
Reference: www.paycheck.in
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Figure 2.21-Market Determined Wage Rate
Figure 2.22-Price Floor above the Market Price (Binding).
A look at Table 2.6 reveals that there are different labor mark ets
for different trades and the wage rates vary across skill levels. The impact
of minimum wage depends upon the skill and experience of the workers.
Highly skilled and experienced workers will always get wages higher than
the minimum wage. The minimum wages in Maharashtra as shown in the
above table are much less than the market wages. As a result, poorlymunotes.in

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skilled workers may be paid the minimum wages as notified by the
government from time to time.
The controversy over minimum wages is around the ar gument that
a rise in minimum wages will reduce employment amongst the poor and
their economic conditions will become miserable. The other argument is
that a rise in minimum wages will improve the economic conditions of
workers who come from the poor fami lies. However, the actual impact of
minimum wages on the labor market depends upon the level of minimum
wages set. If the minimum wages are set below the market determined
wage rates, it will have no impact whatsoever on the labor market. The
minimum wa ges paid in Maharashtra in Zone -I range from a measly
Rs.4056/ -per month paid to cashew processing skilled workers to a
moderate Rs.13224/ -paid to skilled building/road construction workers.
The highest minimum wage paid to a skilled construction worker is way
below the wages paid to a sweeper in government employment. Wage
rates in India in the unorganized labor market are closer to the subsistence
levels because of the low minimum wage rates determined by the
government.
2.22ADMINISTERED PRICE CONTRO L
In the year 1972, the Administered Price Mechanism came into
existence in India in the oil sector. Under this system, the oil and gas
sector was controlled at four stages. These stages are: production,
refining, distribution and marketing . The supply o f raw material to the
refineries at the point of refining was done at a predetermined price called
‘delivered cost of crude’ . The finished products were also made available
at predetermined price called ‘ ex-refinery prices ’. The APM was based
on the princi ple of compensating normative cost and allowing a pre -
determined return on investments to the oil companies. For example,
ONGC and OIL were compensated for their operating expenses and
allowed a 15% post -tax return on the capital employed. Both ONGC and
Oil India Limited (OIL) sold crude to refineries at $7 -8 per barrel when
the prevailing oil price was $17 -19. The Government of India regulated
sourcing and import of crude, its refining as well as its sale till it reached
the end consumer.
The system deve loped by the government continued till the 1980s.
In the 1980s, the demand for oil began to rise rapidly. The finances of the
oil companies came under stress due to rising imports of crude oil at high
prices. Consequently, the government deregulated and d econtrolled the oil
sector. The APM was abandoned in the late 1990s.
Liberalization, Privatization and Globalization were the three
pillars of the New Economic Policy of 1991. Keeping the new policy, the
government opened the refinery sector for private participation which led
to the emergence of one of Reliance Refinery. The decision to liberalize
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mechanism in April 2002. Under the liberalized system, Oil Marketing
Companies (OMCs) we re given the freedom to set retail product prices
based on import parity pricing formula. The domestic refining and retail
sector was also opened to private -sector firms, leading to the emergence of
a small private -sector retailing presence in India consis ting of firms such
as Reliance India Limited. Due to the importance of LPG and kerosene,
per unit subsidy funded from the government’s budget were maintained on
LPG and on a fixed proportion of supplied kerosene. This system
continued till 2004 and thereaf ter the Central Government began to control
upward price revisions. The government used to change the price of petrol
and diesel, and the prices of LPG and kerosene prices have remained
effectively fixed due to heavy subsidy on them. The prices of petrol a nd
diesel were protected because of the importance of these products as
transport fuels. Diesel is important, as it makes up over one -third of
India’s petroleum product consumption, and has uses outside transport,
e.g., as an input into agricultural produc tion.
The end of APM led to the rise of the private -sector in setting up
retail operations. Many petrol pumps belonging to RIL, Shell and Essar
were seen around the country. However, when the prices again came
under the control of the government, these three private firms which had
retail license in India were forced to close their retail outlets across India
because of uneconomical business of retail trading of petrol and diesel.
India maintained price controls on four “sensitive” petroleum products –
petrol, diesel, liquefied petroleum gas (LPG), and kerosene. India’s
government -owned Oil Marketing Companies (OMCs) were tasked by the
Government of India to sell these products in retail markets at a centrally
determined sales price. Upward revisions to p rices in response to higher
global crude prices were rare. The upwards revisions were subject to all
kinds of political implications as well. The objective of these controls was
to insulate consumers against high global crude oil prices. But due to
freque nt ups and downs in the oil prices, the Oil Marketing Companies
started recording significant “under -recoveries” on the sale of sensitive
petroleum products. Under -recoveries are calculated as the difference
between the cost price and the regulated price a t which petroleum products
are finally sold by the OMCs to the retailers after accounting for the
subsidy paid by the government.
A large part of these under -recoveries is compensated for by
additional cash assistance from the government (over and above t he fiscal
subsidy). Some part is also compensated by the upstream companies while
remaining portion remains uncompensated to the OMCs. In 2008, prices
of crude oil in the international market rose rapidly. As a result, the
OMCs under -recoveries went up to USD 25 billion. The Government had
to issue hundreds of billions of Indian rupees to OMCs to counteract mass
under -recoveries since 2005 in order to maintain the solvency of these key
companies. Most of this funding was done using the debt securities call ed
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2.23 SUMMARY
1. Demand can be studied in terms of individual demand and market
demand. Those factors which influences or determines individual demand
also go into determining market demand which is the sum of individual
demands. However, t he same cannot be said of the factors which
determine market demand.
2. A simple demand function can be stated as D x=-f(Px). It reads that
quantity demanded of commodity ‘x’ (D x) is a negative function of price
(P). However, the demand function must fac tor in all possible demand
determinants and therefore a more comprehensive demand function can be
stated as follows: D x=f( P x,Py,Pc,Ps,Y ,E ,T ,A ,U )
3. Market demand for a given product is the sum of individuals demand
for the said product given the price, place and time. The market demand
function can be stated as follows: MDx=f( P x,Y ,P sc,T ,A ,N ,U )
4. Kelvin Lancaster put forward the characteristic or attributes approach to
consumer theory. Kelvin says that consumers demand a g ood because of
the characteristics, properties and attributes of the good which give rise to
utility. A commodity has more than one attribute and any given attribute
is present in more than one commodity.
5. The market demand curve is the horizontal summa tion of the individual
demand curves only if the consumptions decisions of individual
consumers are independent i.e. their decisions are not influenced by
network externalities. If the network externality is negative, consumers
will demand less at the give n price and the demand curve will become
steeper. In case of positive network externality, the consumers will buy
more of a commodity at the given price and the demand curve will
become flatter. The effects caused by network externalities are classified
into snob, bandwagon and Veblen effects.
6. Supply refers to the quantities of a commodity which the seller is
willing and able to provide at different prices during a given period of
time, other things remaining constant. Supply of a commodity is a direct
function of its price.
7. Price remaining constant, when other supply determining factors
change, there is either an increase or a decrease in supply and as a result,
the supply curve changes its position. Thus with an increase in supply, the
supply curv e will shift to the right and with a decrease in supply, the
supply curve will shift to the left.
8. When the supply curve shifts to the left, the firm would be willing to
supply the original quantity at a higher price or a lower quantity at the
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quantity is being supplied at the same price, whereas a vertical upward
shift would indicate that the same quantity would be supplied at a higher
price. Conversely, when the supply curve shif ts to the right, the firms
would be willing to supply the original quantity at a lower price or a larger
quantity at the same price. A horizontal shift to the right would indicate
that the firms would be willing to supply a larger quantity at the same
price, whereas a vertical downward shift would indicate that the firms
would be willing to supply the same quantity at a lower price.
9. The Price Elasticity of Supply can be defined as a percentage change in
the quantity supplied of a commodity as a result o f percentage change in
the price of the commodity. Symbolically, the price elasticity of supply
can be stated as follows:
PES = Percentage change in quantity supplied
Percentage change in price
10. The numerical co -efficient of price elasticity of supply is between zero
and infinity. Thus there can be five possibilities of price elasticity, namely
PES = 1, PES< 1, PES > 1, PES = 0 and PES = . These five values of
co-efficient assume the following five types of price elasticity.
11. Methods o f Measurement of Price elasticity of demand: Percentage /
Ratio Method, Arc Method
12. Cross price elasticity of demand deals with impact of change in the
price of one commodity, say commodity ‘x’ on the quantity demanded of
commodity ‘y’, where these good s are either complementary or substitute
goods. The formula for cross price elasticity of demand can be stated as
follows:
exy=Percentage change in the quantity demanded of commodity 'x'
Percentage change in the price of commodity 'y'
13. The relationship between quantity demanded and the level of income
is direct. A simple income demand function can be stated as Qdx = f(Y)
when Qdx = quantity demanded of commodity ‘x’ Y = level of income.
The co -efficient of income elasticity of demand can be measured as
follows:
ey =Percentage change in the quantity demanded
Percentage change in income
14. The price elasticity of supply at a point on the supply curve can be
measured as follows:
PES =Q
QP
P=Q
QP
P
=Q
OPP
Q=Q2-Q1
P2-P1P1
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15. The paradox of bumper crop explains why the farmers are poorer with
a bumper harvest and richer with a poor harvest.
16. Government will impose taxes on goods and services (indirec t taxes)
to generate revenue. Government may impose an indirect tax on the
buyers or on the sellers. If a tax is imposed on the buyers, the demand
curve will shift to the left. Similarly, if a tax is imposed on the sellers, the
supply curve will shift t o the left. When a tax is imposed either on the
buyer or the seller, the burden of tax is shared by both the buyers and the
sellers.
17. Governments intervene in the market by fixing maximum prices.
During inflationary periods, the government may impose wage and price
controls to arrest the spiraling prices. When a price ceiling is imposed, the
maximum price of a product or a service is prescribed by the government.
Price ceilings can be binding and non -binding. A binding price ceiling is
imposed belo w the equilibrium price whereas a non -binding price ceiling
is imposed above the equilibrium price.
18. Price floors place a legal minimum on the prices. Price floor may be
classified into binding and non -binding price floors. When the
government impose s a price floor which is above the equilibrium price, it
is a binding price floor whereas a price floor imposed below the
equilibrium price is a non -binding price floor.
19. The controversy over minimum wages is around the argument that a
rise in minimum w ages will reduce employment amongst the poor and
their economic conditions w ill become miserable. The other argument is
that a rise in minimum wages will improve the economic conditions of
workers who come from the poor families. However, the actual impact of
minimum wages on the labor market depends upon the level of minimum
wages set. If the minimum wages are set below the market determined
wage rates, it will have no impact whatsoever on the labor market.
20. In the year 1972, the Administered Price Mechanism first came into
existence in India in the oil sector.
2.24QUESTIONS
1.What is demand? Explain the determinants of demand.
2.State and explain the market demand function.
3.Explain the theory of attributes.
4.Explain the concepts of Snob appeal, bandwagon and Veblen effects.
5.Explain the law of supply and the determinants of supply.
6.Account for the shifts in the supply curve.
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8.What is elasticity of supply? Explain the types of elasticity of supply.
9.What is elasticity of demand? Explain the types of elasticity of
demand.
10.Explain the ratio and total outlay methods of measuring price elasticity
of demand.
11.What is income elasticity of demand? Explain income elasticity of
demand in case of normal goods, inferior goods and neutral goods.
12.What is cross price elasticity of demand? Exp lain the cross price
elasticity of demand in case of substitutes, complementary goods and
unrelated goods.
13.Explain the paradox of bumper harvest with suitable diagram.
14.Explain the impact of tax on price and quantity with suitable diagrams.
15.Explain the conc epts of minimum floor and maximum ceilings.
16.Explain the minimum wages controversy with suitable diagrams.

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UNIT -2A
THEORY OF CONSUMER CHOICE
Unit Structure
2A.0 Objectives
2A.1 The Theory o f Consumer Choice
2A.2 Consumer Preferences
2A.3 The Consumer’s Optimal Choices or Equilibrium
2A.4 How Consumer’s Choice i s Affected by Changes in Income
2A.5 Effect of Changes in Prices on Consumer Choices
2A.6 Derivation of the Demand Curve
2A.7 Summary
2A.8 Question
2A.0 OBJECTIVES
To study the Theory of Consumer Choice
To understand Consumer P reference and Budget Constraint
concepts
To study Consumer Equilibrium wit h Indifference Curve
To understand the Effect of Changes in Price and Income on
Consumer Equilibrium
2A.1 THE THEORY OF CONSUMER CHOICE
The theory of consumer choice provides a better understanding of
demand. It examines the trade -offs that people face as consumers. When
a consumer buys one commodity, he sacrifices another commodity. There
is always a trade -off in every transaction that a consumer undertakes. The
cause of the trade -off is the budget constraint and the prices of goods that
the consumer wishes to buy. The theory of consumer choice examines
how consumers facing trade -offs make decisions and how they respond to
changes in their environment.
THE BUDGET CONSTRAINT –WHAT THE CONSUMER CAN
BUY GIVEN HIS INCOME AND PRICES OF GOODS.
People a ttempt to satisfy more than one need at a time. In order to
satisfy simultaneous wants, one has to allocate one’s budget given the
prices of goods that one wants to buy. Eating out every week end and go
for a long drive can be a combination of want that a family wants to
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Washing machine etc and spending on Diwali celebrations or Id
celebrations. In the ordinary course of life, everybody is confronted with
multiple requirements. Budget ing is required to allocate income to satisfy
various requirements. Budgeting means spending less than what one
desires. Budgeting also explains the link between income, prices and
expenditure.
Budget constraint can be explained with an example in which a
consumer wants to buy two goods: Burgers and Coffee. The consumer’s
income is Rs.600 per month. The price of burger is Rs.100 and the price
of Coffee is Rs.50. Given his income of Rs.600, the consumer can
purchase various combinations of burgers and coffee as shown in Table
2A.1.
The first row in Table 2A.1 shows that when the consumer
purchases six burgers, he spends Rs.600 on burgers and hence he is not
able to spend any money on coffee. The other extreme choice available
before the consumer is 12 cups of coffee and zero burgers. The consumer
may choose any other combination of burgers and coffee between these
two extreme limits of the budget. The cost of each choice made in Table
2A.1 is Rs.600. Figure 2A.23 shows the consumpt ion bundles that the
consumer can choose. The vertical axis measures the number of coffee
cups and the horizontal axis measures the number of burgers. All the
combinations of burgers and coffee can be represented in the figure and
the consumer can make a ny one choice. There are three points marked on
the budget line. This budget line may also be called as the price line or the
income line. At point A, the consumer buys zero burgers and 12 cups of
coffee. At point B, the consumer buys six burgers and n o coffee. At point
C, the consumer spends an equal amount on Coffee and Burgers. He buys
six cups of coffee and three burgers. The budget line is called the budget
constraint because given his income and the prices of two goods, the
consumer will have t o be on the budget line. He cannot step out of the
budget line and hence the budget line is the constraining factor on the
consumer’s choice. The budget constraint also shows the trade -offTable 2A.1–The Consumer’s Budget Constraint
Number of
Coffee CupsNumber
of BurgersExpenditure
On CoffeeExpenditure
On BurgersTotal
Expenditure
0 6 0 600 600
2 5 100 500 600
4 4 200 400 600
6 3 300 300 600
8 2 400 200 600
10 1 500 100 600
12 0 600 0 600
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between burgers and coffee or the opportunity cost of making any one
choice.
Figure 2A.1–The Consumer’s Budget Constraint.
The slope of the budget constraint measures the rate at which the
consumer can trade one coffee for burgers. The slope between two points
is calculated as the change in the vertical distance d ivided by the change in
the horizontal distance i.e. rise over run. Front point A to point B, the
vertical distance is 12 cups of coffee and the horizontal distance is six
burgers. Thus the slope is two cups of coffee per burger. Each time the
consumer makes a choice of buying one more burger, he will have to
sacrifice two cups of coffee. The slope of the budget constraint equals the
relative price of the two goods i.e. the price of one commodity as
compared to the other commodity (100 ÷ 50). The budge t constraint slope
of 2 shows the trade -off the market is offering the consumer: one burger
for two cups of coffee.
2A.2 CONSUMER PREFERENCES
The choice made by the consumer depends upon his income, prices
of goods and preferences regarding the two goods . The consumer’s
preferences permit him to choose among different combinations or
bundles of two goods: coffee and burgers. The consumer will be
indifferent between the two goods if he or she has an equal liking for both
the goods. The preferences of a consumer based on his liking can be
represented graphically as shown in Figure 2A..2. The preferences are
represented by a curve called the Indifference Curve (IC). The IC shows
the combinations or bundles of consumption of two goods that make the
consum er equally happy. The IC is therefore known as equal satisfaction
curve or the Iso -utility Curve. In Figure 2A.2, there are two representative
indifference curves of the consumer. In reality, the consumer may have a
set of indifference curves showing his scale of preference. The consumer
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on a given indifference curve. On IC 1, there are points A, B and C. All
these points represent the same level of liking or satisfaction. When the
consumer shifts his position from point A to point B, he prefers more of
burgers than coffee. A movement from point A to point B reduces the
quantity of coffee and increases the quantity of burgers. The level of
satisfaction enjoyed by the consumer r emains the same because the loss of
coffee units is compensated by the gain of burger units.
The slope of the indifference curve at any point equals the rate at
which the consumer is willing to sacrifice or substitute one good for the
other. This rate of substitution is called the marginal rate of substitution
(MRS). In our example of burgers and coffee, the MRS will measure the
number of units of burgers that needs to be compensated for one -unit
reduction in coffee consumption. Since the indifference c urve is bowed
inwards or convex to the origin, the MRS is different at different points of
a given IC. The MRS depends upon the amount of goods that a consumer
is actually consuming. The rate at which the consumer is willing to trade
coffee for burgers d epends upon whether he needs more coffee or more
burgers. The need for more coffee or more burgers depends upon how
much of these two goods the consumer is actually consuming.
In Figure 2A.2, we have two ICs. The consumer will naturally prefer IC 2
toIC1because a higher indifference curve represents bigger bundles of
two goods, here burgers and coffee. A consumer’s set of ICs gives the
scale of preference or the ranking of consumer preferences. Figure 4.2
show that the consumer will prefer point D o nI C 2than any other point on
IC1. Point D on IC 2indicates a larger bundle of two goods but it shows
that the consumer will have fewer cups of coffee than what he had at point
C on IC 1. Yet the consumer will prefer point D because it will
compensate the consumer with much greater quantity of burgers and the
loss of satisfaction due to a lower quantity of coffee will be compensated
by a much larger quantity of burgers.
Figure 2A.2–The Consumer’s Preferences .munotes.in

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PROPERTIES O F INDIFFERNCE CURVE.
The indifference curves represent the preferences of consumers.
The properties that represent consumer’s preferences are four in number.
1.Higher Indifference Curve is preferred to a lower one. In the
absence of prices and budget cons traint, the consumer will like to
consume a larger bundle of goods than smaller. A higher indifference
curve represents a larger bundle of goods than a lower one and hence
the consumer will prefer a higher IC to a lower IC. In Figure 4.2, the
consumer wi ll prefer IC 2to IC 1.
2.Indifference Curves are downward sloping. The slope of the
indifference curve shows the rate at which the consumer is willing to
substitute or sacrifice one good for the other. In order to keep the
satisfaction level same as before , the consumer will have to be
compensated for the loss of consumption when he moves along the
indifference curve. Thus if the quantity of burgers increase s, the
quantity of coffee must decrease.
3.Indifference curves do not cross each other. If indiffe rence curves
intersect or cross each other they will have common points indicating
that the consumer is indifferent between points placed on a higher and
lower curve. Such a conclusion will be in contradiction with the
assumption that a rational consumer will prefer a larger bundle of
goods to a smaller one. The contradiction can be seen in Figure 4.3.
Points A and B are on IC 1indicating that the consumer will get the
same level of satisfaction at these two points and hence will be
indifferent between t hem. Similarly points B and C are on IC 2
indicating that both points give equal satisfaction to the consumer.
Since IC 2is a higher indifference curve, a rational consumer must
prefer point B to A. Further point C is also on IC 2and clearly lying
above IC1. The consumer will have to be indifferent between points A
and C either. Intersecting indifference curves are therefore a
contradiction to the basic assumption of the theory of consumer
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Figure 2A.3–Intersecting Indifference Curves.
4.Indifference curves are bowed inward or are convex to the origin.
The slope of the indifference curve is the marginal rate of substitution
(MRS). The MRS must decrease as the consumer moves from left to
right on the indifference curve. The MRS decreases b ecause as the
quantity of burgers increase, the quantity of coffee decreases and its
relative importance increases. Decreasing or diminishing MRS is
possible only when the IC is downward sloping and convex to the
origin or bowed inward. Diminishing MRS c an be seen in Figure
2A.4. Initially, the consumer is willing to give up one burger for four
cups of coffee at point A and hence MRS is four. But at point B, the
consumer is willing to sacrifice one burger for only one cup of coffee.
His MRS falls to on e. This is because at point B, the stock of burgers
is much larger than at point A and the stock of coffee is much smaller
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Figure 2A.4–Convex or Inwardly Bowed IC .
Check your progress:
1. Explain the Theory of consumer choice.
2. State the properties of indifference curve.
____________________________________________________________
____________________________________________________________
____________________________________________________________
____________________________________________________________
____________________________________________________________
2A.3 THE CONSUMER’S OPTIMAL CHOICES OR
EQUILIBRIUM
Given the number of indifference curves, the consumer would like
to prefer the high est indifference curve because it has the largest bundle of
two goods. But the budget constraint is the limit within which consumer
can make a choice of his bundle of two goods. The budget constraint is a
function of the income of the consumer and the pri ces of two goods that
the consumer is willing to consume. The consumer’s optimum choice or
his equilibrium is shown in Figure 2A.5. The highest indifference curve
that the consumer can reach given his budget constraint is IC 2which
touches the budget lin e or is tangent to the budget line at point B. Point C
is on IC 3. The consumer cannot choose IC 3because it is lying above the
budget line. IC 1is lying below the budget line and the consumer can
afford IC 1but it will give a lower level of satisfaction . Point B is the
optimum choice because it represents the best combination of
consumption of coffee and burgers. At point B, the slope of the budget
line and that of IC 2are equal. The slope of the IC shows the MRS
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relative price or the price ratio of coffee and burgers. The consumer
chooses the combination of coffee and burgers in such a manner that the
MRS is equal to the price ratio or the relative prices of two goods. The
price r atio is the rate at which the market trades one good for another. In
our example of coffee and burgers, one burger is traded for two cups of
coffee. The MRS is the rate at which the consumer is willing to trade one
good for another. At the optimum point B, the consumer’s valuation of
the two goods equals the valuation by the market. Due to consumer
optimization, market prices of different goods show the value that
consumers place on the combination of two goods.
Figure 2A.5–The Consumer’s Optimum o rE q u i l i b r i u m .
2A.4 HOW CONSUMER’S CHOICE IS AFFECTED BY
CHANGES IN INCOME
When the income of the consumer increases, he can afford a larger
quantity of goods. Increase in income shifts the budget line to the right as
shown in Figure 2A.6. Price remain ing constant, the price ratio or the
relative prices of two goods also remain constant. The slope of the new
budget constraint is equal to that of the old budget constraint. There is a
parallel shift in the budget line or budget constraint.
The new budg et constraint allows the consumer to purchase more
of coffee and burgers by reaching a higher indifference curve. The new
budget line and the new indifference curve are tangent to each other at
point B. Point B is the new optimum or equilibrium of the co nsumer. The
optimum point reveals that the consumer has opted for a larger quantity of
both coffee and burgers. This is because both coffee and burgers are
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Figure 2A.6–The Consumer’s New Optimum or Equilibrium .
Figure 2A.7 shows how an increase in income causes the consumer to buy
more of burgers but less of coffee cups. When a consumer buys less of a
commodity when his income increases such a commodity is known as an
inferior good. A good is not inferior in itself. Infer iority of a good is
relative to the income of the consumer. A consumer may ascribe a normal
status to a good at a lower level of income and when his income increases,
he may ascribe an inferior status to the same good. Ascribing an inferior
status to a go od is not always objective. It is more often subjective
because it is the monetary status of the consumer that makes a commodity
inferior or normal. Thus at a lower level of income, hiring a taxi for your
daily commute may be normal but at a higher level of income driving
one’s own car may be considered normal and at still further higher level of
income, chauffer driven car may be considered normal.
In the vegetable market across the Mumbai city and suburbs, one
may find a variety of tomatoes in terms of their size and skin texture.
Well shaped red tomatoes of an average size can be objectively considered
superior to ill -shaped yellowish tomatoes. It will be natural to a consumer
to purchase better tomatoes with an increase in income and consider the
yellowish unripe tomatoes to be inferior. The income effect in case of an
inferior good is always negative i.e. a consumer will purchase a lesser
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Figure 2A.7–Income Effect in case of Inferior Good .
2A.5 EFFECT OF CHANGES IN PRICES ON
CONSUMER CHOICES
When the price changes, there is a change in consumer choice. If
the price of coffee measured along the vertical axis falls from Rs.50 to
Rs.25, the budget constraint or the budget line will shift outward with the
pivot on the horizontal axis remaining constant. The consumer can now
purchase 24 cups of coffee with his income of Rs.600. In order to reflect
the new purchasing power in terms of coffee, the budget constraint mo ves
from point A to C. The new budget constraint is now CB. The slope of
new budget constraint has become steeper towards the vertical axis. With
the change in the relative prices of coffee and burgers, the consumer can
now trade one burger for four cu ps of coffee. However, the change in
consumer choice will be determined by his preferences. The new
optimum of the consumer is shown in Figure 2 A.9 which is to the left of
the original optimum. The new optimum indicates that the consumer has
preferred a larger quantity of coffee and a lesser quantity of burgers.
INCOME AND SUBSTITUTION EFFECTS.
The impact of changes in price of a commodity on consumption
can be divided into two effects, namely; the income effect and the
substitution effect. When the c onsumer decides to buy a larger quantity of
both the goods, it is known as income effect. However, the relative price
of burger has risen i.e. now the consumer would need four cups of coffee
to trade with one burger. The consumer would therefore choose t ot r a d e
more burgers for coffee because coffee has become hundred per cent
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Considering coffee and burgers to be normal goods, the income effect will
be positive in both the cases i.e. the c onsumer will buy a larger quantity of
both the goods because the purchasing power has risen. However, the
substitution effect for coffee will be positive because the price of coffee
has fallen and that of burgers will be negative because the relative pric e of
burgers has risen. Since both the income and substitution effects are
positive in the case of coffee, the total effect or the price effect is also
positive. In the case of burgers, the income effect is positive but the
substitution effect is negative . Hence the net price effect or total effect is
not clear or is ambiguous.
Figure 2A.9 shows the distribution of price effect into income and
substitution effects. When the price of coffee falls, the consumer moves
from the initial optimum point A to the new optimum point C. This
movement from A to C takes place in two steps. To begin with, the
consumer moves along the initial indifference curve IC 1from point A to
point B. Since points A and B are on the same IC, these points give equal
satisfactio n to the consumer but at point B the MRS reflects the new
relative price. The dashed line through point B shows the new relative
price. It is drawn parallel to the new budget constraint. Since there is a
rise in real income of the consumer, he moves fro m point B to point C
which is on a higher indifference curve IC 2. Both points B and C have the
same MRS because the slope of IC 1at point B is equal to the slope of IC 2
at point C. The hypothetical line helps to separate the income and
substitution effe cts which determine the consumer’s new preference. The
movement from point A to point B shows a pure change in the MRS
without any change in the welfare of the consumer. The change from
point B to point C represents a pure change in consumer’s welfare wit hout
any change in the MRS. Thus the movement from point A to point B
shows the substitution effect and the movement from point B to point C
shows the income effect.
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Figure 2A.9–Income and Substitution Effects .
2A.6 DERIVATION OF THE DEMAND CURVE
The demand curve for goods reflects the consumption decisions of
the consumer. The demand curve is a reflection of the optimal decisions
taken by the consumer given his budget constraint and the indifference
curves . For example, Figure 2A.10 considers the demand for coffee.
Panel (a) shows that the price of coffee falls from Rs.50 to Rs.25 and the
consumer’s budget constraint shifts outward to become steeper towards
the vertical axis. This outward shift indicates the increase in purchasing
power of the consumer in terms of coffee. Since the price of burgers has
not changed, the origin of the new budget constraint remains the same.
Due to the positive substitution and income effects, the demand for coffee
rises f rom 6 cups to 18 cups. Panel (b) shows the demand curve that is
based on the new optimal decision taken by the consumer. The theory of
consumer choice thus provides the theoretical foundation for the
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Figure 2A.10 (a) –The Consumer’s Optimum .
Figure 2A.10 (b) –The Demand Curve for Coffee .
2A.7 SUMMARY
1. The theory of consumer choice provides a better understanding of
demand. It examines the trade -offs that people face as consumers. The
theory of consumer choi ce examines how consumers facing trade -offs
make decisions and how they respond to changes in their environment.
2. The consumer’s preferences permit him to choose among different
combinations or bundles of two goods: coffee and burgers. The consumer
will be indifferent between the two goods if he or she has an equal liking
for both the goods.
3.The slope of the indifference curve at any point equals the rate at which
the consumer is willing to sacrifice or substitute one good for the other.
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4. Given the number of indifference curves, the consumer would like to
prefer the highest indifference curve because it has the largest bundle of
two goods. But the budget constraint is the limit within which consumer
can make a choice of his bundle of two goods. The budget constraint is a
function of the income of the consumer and the prices of two goods that
the consumer is willing to consume.
5. The impact of changes in price of a commodi ty on consumption can be
divided into two effects, namely; the income effect and the substitution
effect. When the consumer decides to buy a larger quantity of both the
goods, it is known as income effect. However, the relative price of burger
has risen i .e. now the consumer would need four cups of coffee to trade
with one burger. The consumer would therefore choose to trade more
burgers for coffee because coffee has become hundred per cent cheaper in
real terms. This is known as the substitution effect.
6. The demand curve for goods reflects the consumption decisions of the
consumer. It is a reflection of the optimal decisions taken by the consumer
given his budget constraint and the indifference curves.
2A.8 QUESTIONS
1.Explain the concept of consumer preference and budget constraint.
2.Explain the concept of consumer optimum with indifference curve.
3.Explain the effect of changes in price and income on consumer’s
optimal decision making in case of a normal good.
4.Explain the effect of changes in price and income on consumer’s
optimal decision making in case of an inferior good.
5.Derive the demand curve with the help of indifference curve.
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UNIT -III
UNIT -3
PRODUCTION DECISIONS AND COST
ANALYSIS
Unit Structure:
3.0 Objectives
3.1 Introduction: Production Function
3.2 Long -Run Vs Short -Run Production Function
3.3 Isoquants
3.4 Isoquant Map
3.5 Properties of Isoquants
3.6 Iso-Cost Lin es/Outlay Line/Price Line/Factor Cost Line
3.7 Marginal Rate of Technical Substitution (Mrts)
3.8 Optimum Factor Combination
3.9 Summary
3.10 Question
3.0 OBJECTIVES
To familiar students with Concept of Production Function
To acquaint the students wit h Nature of short run and long run
Production Function
To study the Law of variable proportion & Laws of Returns to scale
Economies of Scale
To understand the concept of Expansion path and Multiproduct firm
To Study Cost reduction through experience -Learning curve
3.1INTRODUCTION: PRODUCTION FUNCTION
Production is an activity of utter importance for any economy. In fact,
an a t i o nw i t hah i g hl e v e lo fp r o d u c t i v ea c t i v i t i e ss p e a r h e a d st h ep r o s p e r i t y
charts. This is because raw goods, surely are valuable ,b u tp r o d u c t i o nd o n e
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Since the primary purpose of economic activity is to produce
utility for individuals, we count as production during a time period all
activity which either cr eates utility during the period or which increases
ability of the society to create utility in the future. Business firms are
important components (units) of the economic system.
They are artificial entities created by individuals for the purpose of
organ izing and facilitating production. The essential characteristics of the
business firm is that it purchases factors of production such as land,
labour, capital, intermediate goods, and raw material from households and
other business firms and transforms tho se resources into different goods or
services which it sells to its customers, other business firms and various
units of the government as also to foreign countries.
3.1.1 Definition ofProduction:
According toBates andParkinson:
Production is the organ ized activity of transforming resources into
finished products in the form of goods and services; the objective of
production is to satisfy the demand for such transformed resources”.
We now know the meaning of production, that production creates or
adds utility. There are various processes through which we can achieve the
aim of utility creation or addition to ultimately satisfy human wants. These
processes are as follows:
The manufacturing processes that take physical inputs and produce
physical outputs ,e v e n t u a l l yi n c r e a s i n gt h eu t i l i t yo ft h er e s o u r c eb e i n g
manufactures, are integral branches in the production tree. These processes
are the most obvious forms of production. They change the form of the
goods under concern, in order to satisfy a greater h uman want.
For example, changing a log of wood into a table or chair is a
manufacturing process. Further, such processes add to the utility of form of
the raw materials.
3.1.2 Meaning ofProduction Function:
Ineconomics, a production function gives the technological
relation between quantities of physical inputs and quantities of output of
goods. The production function is one of the key concepts
ofmainstream neoclassical theories, used to define marginal product and
to distinguish allocative efficienc y, a key focus of economics. One
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distribution of income to those factors, while abstracting away from the
technolog ical problems of achieving technical efficiency, as an engineer or
professional manager might understand it.
In simple words, production function refers to the functional
relationship between the quantity of a good produced (output) and factors
of product ion (inputs).The production function of a firm depends on the
state of technology. With every development in technology, the
production function of the firm undergoes a change.
The new production function brought about by developing
technology displays sa me inputs and more output or the same output with
lesser inputs. Sometimes a new production function of the firm may be
adverse as it takes more inputs to produce the same output.
Mathematically, such a basic relationship between inputs and outputs may
beexpressed as:
Q=f (L ,C ,N)
Where Q = Quantity of output
L = Labour
C = Capital
N = Land.
Hence, the level of output (Q), depends on the quantities of
different inputs (L, C, N) available to the firm. In the simplest case, where
there are only two inpu ts, labour (L) and capital (C) and one output (Q),
the production function becomes.
Q= f( L ,C )
The efficiency of this relationship depends on the different
quantities used in the production process, the quantities of output and the
productivity at each p oint. It can be shown algebraically:
O=f( I 1,I2,I3,I4…….. Z n)
Where, O = quantity of output
I1,I2,I3= Quantity of different inputs
It can be classified on the basis of the substitutabilit y of the inputs by other
inputs.
3.2LONG -RUN VS SHORT -RUNPRODUCTION
FUNCTION
What is that separates long -run from short -run in economic
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this regards, factors of production are classified into long -run and short -
run based on the variabili ty i.e. time they take to be variable. Doing this is
beneficial for us to thoroughly examine and understand the theories of
production.
In fact, short -run in economics is a time interval, in which we
cannot even change a single factor input. This way a pr oduction function
is short -run when at least one factor input cannot be changed during the
period. In other terms, when not all factors of production is variable then a
production function is short -run, and called short run production function.
Hence, at l east one factor input must be fixed in the short -run production
function.
On the other hand, all the factor inputs are variable in long -run
production function. Long -run is defined as the time period in which all
factor inputs, that are included in produc tion function, can be changed.
However, there is no specific law that stipulates the short -and long -run. It
is all about the theory, but in practice, it depends on the nature of
production activity that determines short -and long -run. That is why, a
pract ical thinking of economists is that long -run is a planning period in
which decisions regarding investment in new plant and machinery can be
undertaken, whereas short -run involves the operations from existing plant
and machinery.
3.2.1 Fixed vs Variable Pr oportion Production Function
Lets us first understand the concept of proportion before starting
the topic. Proportion refers to the equality of two ratios, that is, connecting
two ratios by equality sign results in proportion. This way ratios are the
integral parts of proportion, and we mean proportion here to refers to the
equality of different capital -labor ratios.
Also one more thing to consider here is a term called technical
coefficients ofproduction , which is the amount of factor inputs required
toproduce a certain commodity. For example, suppose that it needs 10
units of capital to produce 50 units of particular commodity, then technical
coefficient of capital for production is 0.2. If we were to express it in
percentage basis, it requires 20 perc ent capital to produce 50 units of
commodity.
Now that we define proportion and technical coefficients of
production, it is time to describe fixed and variable proportion production
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depends on the technical coefficients of production. If technical
coefficients of factors are constant, then the production function is fixed or
constant proportion production function, otherwise, variable proportion
production function.
In fixed constant p roportion production function, capital -labour
ratio remains fixed no matter how large the scale of production is, as
opposed to variable proportion production function. Likewise, there is
zero marginal rateoftechnical substitution between factor inputs -capital
and labor -in fixed or constant proportion production function, which
means factors, are perfect complements. On the other hand, there might
be limited factor substitutability or the perfect substitutes in case of
variable proportion production fu nction.
3.2.2 Linearly Homogeneous Production Function
If the multiplication of each factor inputs of a production function
by a constant ‘j’ leads to the multiplication of output by jr, then the
production function is said to be homogeneous of degree r .
Mathematically, the general homogeneous production function of
degree r is written as:
jrQ= F(jL, jK) where j, r > 0 …………………. (III)
where, Q is output, L is labor, K is capital, and j and r are constant greater
than zero. However, j and r can take an y value, but we take these value as
positive from the aspect of economic variables which are rarely negatives.
When the value of r in equation (III) is 1, then the homogeneous
production function is of first degree, which is also the linearly
homogeneous production function we refer to. That means jQ= F(jL, jK)
is linearly homogeneous production function and implies that multiplying
factor inputs by constant j results in the multiplication of output by the
same constant j. Thus it shows the constant retur ns to scale.
3.2.3 Characteristics of Homogeneous Production Function
General homogeneous production function jrQ= F(jL, jK) exhibits the
following characteristics based on the value of r.
If r = 1, it implies constant returns to scale. In such a case, production
function is said to be linearly homogeneous of first order.
If r > 1, it implies increasing returns to scale.
If r < 1, it implies decreasing returns to scale.
Due to it’s simplicity and good approximation of real world
situation, this product ion function is widely used in linear programming
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3.2.4 Cobb -Douglas Production Function
This very famous Cobb -Douglas production function is a long -run
production function, and is the result of combined efforts of professor of
economics cum U.S. senator Paul Douglas and mathematician Charles
Cobb. Douglas observed U.S. data and found that the shares of national
income to labor and capital remained almost constant over the long time -
period. Put another way, despite continuous growt h in national income,
proportionate share of labor and capital to national income almost grew at
the constant rate. The very fact is depicted in the special case of Cobb -
Douglas production function.
Mathematically, the general Cobb -Douglas production func tion is written
as:
Q= F(L,K) = A K αLβwhere A, α,β> 0 …………………. (IV)
where, Q is output, αis output elasticity of capital, βis output elasticity of
labor, and A is productivity or total factor productivity measuring
productivity of production functio n or technology or factor inputs in total.
And, all of these parameters are positive. If production technique
advances, it raises the value of productivity parameter, A. Raising value of
total factor productivity, A, equally means that productivity of both labor
and capital has increased.
The parameters αandβ, which also measure the shares of national
income to capital and labor, are distribution parameters. That is parameters
αandβmeasure the contribution of capital and labor to total production or
national income. Note that the usage of Cobb -Douglas production function
here is in macro sense, that’s why it is often called as aggregate production
function. However, it can be used in the micro sense as well.
3.2.5 Characteristics of Cobb -Douglas Production Function
Lets observe the Cob b-Douglas production function Q = A K αLβ
supposing that we change capital and labor by some constant multiple of
λ, which results the right side of function as:
A (λK)α (λL)β = λα+β A Kα Lβ = λα+β . Q
which implies that increasing the factor inputs by mul tiple of some
constant λ, output increase by the multiple of λα+β. That means
coefficient λα+β shows the joint contribution of capital and labor to
output. More specifically, coefficient α+βis a measure of returns to scale.
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Ifα+β= 1, it implies constant returns to scale. In such a case, production
function is said to be linearly homogeneous of first order.
Ifα+β> 1, it implies increasing returns to scale.
Ifα+β< 1, it implies decreasing retur ns to scale.
In case of linearly homogeneous production function of first order, the
following features holds true:
Cobb -Douglas production function exhibits constant returns to scale.
That means doubling the factor inputs doubles the output by the same
proportion.
It demonstrates diminishing returns i.e. marginal product of factor
diminishes. More precisely, marginal product of a factor input
decreases as it is used more and more, holding constant the other
factor inputs.
It exhibits the unit elasticity of factor substitution (For more read
here). Initially, the Cobb -Douglas production was used in
manufacturing industry. Now, it is widely used in empirical studies as
well.
3.2.6 CES Production Function
CES stands for constant elasticity of substitution. T his latest CES
production function is due to the joint effort of Arrow Chenery, Minhas
and Solow. This CES production function is more general production
function which yields the constant elasticity of factor substitution other
than 1.
Mathematically, the general CES production function is written as:
Q= A[ K-ρ + (1-)L-ρ]-1/ρ where A > 0, 0<<1,-1<ρ≠0 …………… (V)
where, Q is output, L is labor, K is Capital, A is efficiency parameter
serving as state of technology as A in Cobb -Douglas production functio n,
is distribution parameter showing relative factor shares as αandβisCobb -
Douglas production function, and ρ is substitution parameter which has no
counterpart in Cobb -Douglas production and is determinant of constant
elasticity of substitution in CES production function.
The elasticity of substitution between factors (σ) is given by 1/(1+ρ) in the
CES production function i.e. σ = 1/(1+ρ).
3.2.7 Characteristics of CES Production Function
CES production function is linearly homogeneous and exhibits the
constant returns to scale. Based on the value of ρ, it produces the
following results for σ:
When -1<ρ<0, then σ >1.
When ρ = 0, then σ = 1.
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Cobb -Douglas production function is special case of CES
production function when t here is unitary elasticity of substitution. This
means that linearly homogeneous CES production function is Cobb -
Douglas production function producing constant returns to scale.
3.3 ISOQUANTS
3.3.1 Definition and Meaning:
The word 'iso' is of Greek or igin and means equal or same
and'quant' means quantity. An iso-quant may be defined as:
"A curve showing all the various combinations of two factors that
can produce a given level of output. The iso -quant shows the whole range
of alternative ways of pro ducing the same level of output".
The modern economists are using iso -quant, or "ISO" product
curves for determining the optimum factor combination to produce certain
units of a commodity at the least cost.
3.3.2 Schedule:
The concept of iso -quant or equal product curve can be better
explained with the help of schedule given below:
Table 3.1
Combinations Factor X Factor Y Total Output
A1 14100 METERS
B 2 10 100 METERS
C3 7100 METERS
D 4 5 100 METERS
E5 4100 METERS
In the table g iven above, it is shown that a producer employs two
factors of production X and Y for producing an output of 100 meters of
cloth. There are five combinations which produce the same level of output
(100 meters of cloth).
The factor combination A using 1 u nit of factor X and 14 units of
factor Y produces 100 meters of cloth. The combination B using 2 units of
factor X and 10 units of factor Y produces 100 meters of cloth. Similarly
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ofX and 5 units of Y, 5 units of X and 4 units of Y produce 100 units of
output, each. The producer, here., is indifferent as to which combination of
inputs he uses for producing the same amount of output.
The alternative techniques for producing a given level of output
can be plotted on a graph.
Figure 3.1
The figure 3 .1 shows y the 100 units iso -quant plotted to ISO
product schedule. The five factor combinations of X and Y are plotted and
are shown by points a, b, c, d and e. if we join these po ints, it forms an
‘iso-quant ’.
An iso -quant therefore, is the graphic representation of an iso -
product schedule. It may here be noted that all the factor combinations of
X and Y on an iso -product curve are technically efficient combinations.
The produc er is indifferent as to which combination he uses for
producing the same level of output. It is in this way that an iso product
curve is also called ‘production indifference curve ’. In the figure 12.1, ISO
product IP curve represents the various combinatio ns of the two inputs
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3.4 ISOQUANT MAP
Aniso-quant map shows a set of iso -product curves. Each iso -
quant represents a different level of output. A higher iso -quant shows a
higher level of out put and a lower iso -quant represents a lower level of
output.
Figure 3.2
In the figure 3 .2, a family of three iso -product curves which
produce various level of output is shown. The iso product IQ1yields 100
units of output by using quantities of i nputs X and Y. So is also the case
with iso -quant IQ3yielding 300 units of output.
We conclude that an iso -quant map includes a series, of iso -
product curves. Each iso -quant represents a different level of output. The
higher the iso -quant output, the fu rther right will be the iso -quant.
3.5 PROPERTIES OF ISOQUANTS
The main properties of the iso-quants are similar to those of
indifference curves. These properties are now discussed in brief:
(i) An Iso -quant Slopes Downward from Left to Right:
This i mplies that the Iso -quant is a negatively sloped curve. This is
because when the quantify of factor K (capital) is increased, the quantity
of L (labor) must be reduced so as to keep the same level of output.munotes.in

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Figure 3.3
Thefigure (3.3) depicts that an i so-quant IP is negatively sloped
curve. This curve shows that as the amount of factor K is increased from
one unit to 2 units, the units of factor L are decreased from 20 to 15 only
so that output of 100 units remains constant.
(ii) An Iso -quant that Lie s Above and to the Right of Another
Represents a Higher Output Level:
It means a higher iso -quant represents higher level of output.
Figure 3.4
The figure 3.4 represents this property. It shows that greater output
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X and Y. The producer increases the output from 100 units to 200 units by
increasing the quantity combination of both the X and Y. The combination
of OC of capital and OL of labor yield 100 units of production. The
production can be increased to 200 units by increasing the capital from OC
to OC 1and labor from OL to OL 1.
(iii) Iso -quants Cannot Cut Each Other:
The two iso -quants cannot intersect each other.
Figure 3.5
If two iso -quant are drawn to inte rsect each oth er as is shown in
this figure 3 .5, then it is a negation of the property that higher Iso -quant
represents higher level of output to a lower Iso -quant. The intersection at
point E shows that the same factor combination can produce 100 units as
well as 200 units. But this is quite absurd. How can the same level of
factor combination produce two different levels of output, when the
technique of production remains unchanged. Hence two iso -quants cannot
intersect each other.
(iv)Iso-quants are C onvex to the Origin :
This property implies that the marginal significance of one factor
in terms of another factor diminishes along an ISO product curve. In other
words, the iso -quants are convex to the origin due to diminishing marginal
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Figure 3 .6
In this figure 3 .6 MRSKLdiminishes from 5:1 to 4:1 and further to
3:1. This shows that as more and more units of capital (K) are employed to
produce 100 units of the product, lesser and lesser units of labor (L) are
used. Hence dim inishing marginal rateof technical substitution is the
reason for the convexity of an iso -quant.
(v) Each Isoquant is Oval Shaped:
The iso product curve, is elliptical. This means that the firm
produces only those segments of the iso -product curves wh ich are convex
to the origin and lie between the ridge lines. This is the economic region
of production.
Check your progress:
1. Explain the meaning of production function.
2. Distinguish between short run and long run production function.
3. State the c haracteristics of Cobb -Douglas production function.
4. Explain the meaning of Iso -quant.
5. Discuss the properties of Iso -quants.
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3.6ISO-COST LINES/OUTLAY LI NE/PRICE
LINE/FACTOR COST LINE
A firm can produce a given level of output using efficiently
different combinations of two inputs. For choosing efficient combination
of the inputs, the producer selects that combination of factors which has
the lower cost of production. The information about the cost can be
obtained from the iso-cost lines.
Explanation:
An iso -cost line is also called outlay line or price line or factor cost
line. An iso -cost line shows all the combinations of labor and capital that
are available for a given total cost to -the producer. Ju st as there are infinite
number of iso-quants , there are infinite number of iso -cost lines , one for
every possible level of a given total cost. The greater the total cost, the
further from origi n is the iso -cost line.
Example:
The iso -cost line can be explained easily by taking a simple example.
Diagram/Figure:
Figure 3 .7
Let us examine a firm which wishes to spend $100 on a
combination of two factors labor and capital for producing a given level of
output. We suppose further that the price of one unit of labor is $5 per day.
This means that the firm can hire 20 units of labor. On the other hand ifmunotes.in

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the price of capital is $10 per unit, the firm will purchase 10 units of
capital. In the fig. 3 .7, the point A shows 10 units of capital used whereas
point T shows 20 units of labor are hired at the given price. If we join
points A and T, we get a line AT. This AT line is called iso-cost line or
outlay line. The iso -cost line is obtained with an outlay of $100.
Let us assume now that there is no change in the market prices of
the two factors labor and capita! but the firm increases the total outlay to
$150. The new price line BK shows that with an outlay of $150, the
producer can purchase 15 units of capital or 30 units of labor. The new
price line BK Shifts upward to the right. In case the firm reduces the
outlay to $50 only, the iso -cost line CD shifts downward to the left of
original iso -cost line and remains parallel to the original pr ice line.
The iso -cost line plays a similar role in the firm ’s decision making
as the budget line does in consumer ’s decision making. The only
difference between the two is that the consumer has a single budget line
which is determined by the income of t he consumer. Whereas the firm
faces many iso -cost lines depending upon the different level of
expenditure the firm might make. A firm may incur low cost by producing
relatively lesser output or it may incur relatively high cost by producing a
relatively la rge quantity.
3.7MARGINAL RATE O F TECHNICAL
SUBSTITUTION (MRTS)
Prof. R.G.D. Alien and J.R. Hicks introduced the concept of MRS
(marginal rate of substitution) in the theory of demand. The similar
concept is used in the explanation of producers equili brium and is named
asmarginal rate of technical substitution (MRTS).
Marginal rate of technical substitution (MRTS) is:
“The rate at which one factor can be substituted for another while holding
the level of output constant ”.
The slope of an iso -quant shows the ability of a firm to replace one
factor with another while holding the output constant. For example, if 2
units of factor capital (K) can be replaced by 1 unit of labor (L), marginal
rate of technical substitution will be thus:
MRS = ΔK=2=2
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Explanation:
The concept of MRTS can be explained easily with the help of the
table and the graph, below:
Schedule:
Table 3.2Factor
CombinationsUnits ofLabourUnits ofCapitalUnits of Output ofCommodity XMRTS of Labourfor CapitalA115150-B2111504:1C381503:1D461502:1E551501:1
It is clear from the above table that all the five different
combinations of labor and capital that is A, B, C, D and E yield the same
level of output of 150 units of commodity X, As we move down from
factor A to factor B, then 4 units of capital are required for obtaining 1
unit of labor without affecting the total level of output (150 units of
commodity X).
The MRTS is 4:1. As we step down from factor comb ination B to
factor combination C, then 3 units of capital are needed to get 1 unit of
labor. The MRTS of labor for capital 3:1. If we further switch down from
factor combination C to D, the MRTS of labor for capital is 2:1. From
factor D to E combination, the MRTS of labor for capital falls down to
1:1.
Formula:
MRTS LK=ΔK
ΔL
It means that the marginal rate of technical substitution of factor
labor for factor capital (K) (MRTS LK) is the number of units of factor
capital (K) which can be substituted by one unit of factor labor (L)
keeping the same leve l of output. In the figure 12.8, all the five
combinations of labor and capital which are A, B, C, D and E are plotted
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Figure 3 .8
The points A, B, C, D and E are joined to form an iso -quant.
Theiso-product curve shows the whole range of factor combinations
producing 150 units of commodity X. It is important to point out that ail
the five -factor combination of labor and capital on an iso -product curve
are technically efficient combinations. The producer is indifferent towards
these, combi nations as these produce the same level of output.
3.7.1 Diminishing Marginal Rate of Technical Substitution:
The decline in MRTS along an iso-quant for producing the same
level of output is named as diminishing marginal rates of technical
education. As we have seen in Fig. 3.8, that when a firm moves down
from point (a) to point (b) and it hires one more labor, the firm gives up 4
units of capital (K) and yet remains on the same iso -quant at point (b). So
the MRTS is 4. If the firm hires another labor and moves from point (b) to
(c), the firm can reduce its capital (K) to 3 units and yet remain on the
same iso -quant. So the MRTS is 3. If the firm moves from point (C) to
(D), the MRTS is 2 and from point D to e, the MRTS is 1. The decline in
MRTS along an iso -quant as the firm increases labor for capital is
called Diminishing Marginal Rate of Technical Substitution.
3.8 OPTIMUM FACTOR COMBINATION
In the long run, all factors of production can be varied. The profit
maximization firm will choose the le ast cost combination of factors to
produce at any given level of output. The least cost combination or themunotes.in

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optimum factor combination refers to the combination of factors with
which a firm can produce a specific quantity of output at the lowest
possible co st.
Explanation:
There are two methods of explaining the optimum combination of
factor:
(i) The marginal product approach.
(ii) The isoquant /iso-costapproach.
These two approaches are now explained in brief:
(i) The Marginal Product Approach:
In the long run, a firm can vary the amounts of factors which it
uses for the production of goods. It can choose what technique of
production to use, what design of factory to build, what type of machinery
to buy. The profit maximizatio n will obviously want to use that mix of
factors of combination which is least costly to it. In search of higher
profits, a firm substitutes the factor whose gain is higher than the other.
When the last rupee spent on each factor brings equal revenue, the profit
of the firm is maximized. When a firm uses different factors of production
or least cost combination or the optimum combination of factors is
achieved when:
Formula:
Mpp a=Mpp b=Mpp c=Mpp n
Pa Pb Pc Pn
In the above eq uation a, b, c, n are different factors of production.
Mpp is the marginal physical product. A firm compares the Mpp / P ratios
with that of another. A firm will reduce its cost by using more of those
factors with a high Mpp / P ratios and less of those wi th a low Mpp / P
ratio until they all become equal.
(ii) The Iso -quant / Iso -cost Approach:
The least cost combination of -factors or producer's equilibrium is
now explained with the help of iso -product curves and iso -costs. The
optimum factors c ombination or the least cost combination refers to the
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As we know, there are a number of combinations of factors which
can yield a given level of output. The producer has to choose, one
combination out of these which yields a given level of output with least
possible outlay. The least cost combination of factors for any level of
output is that where the iso -product curve is tangent to an iso -cost curve.
The analysis of producers equilibrium is based on the following
assumptions.
3.8.1 Assumptions of Optimum Factor Combination:
The main assumptions on which this analysis is based areas under:
(a) There are two factors X and Y i n the combinations.
(b) All the units of factor X are homogeneous and so is the case with units
of factor Y.
(c) The prices of factors X and Y are given and constants.
(d) The total money outlay is also given.
(e) In the factor market, it is the perfect co mpletion which prevails. Under
the conditions assumed above, the producer is in equilibrium, when the
following two conditions are fulfilled.
(1) The isoquant must be convert to the origin.
(2) The slope of the Isoquant must be equal to the slope of isocost line .
The least cost combination of factors is now explained with the
help of figure 3 .9.
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Here the iso -cost line CD is tangent to the iso -product curve 400
units at point Q. The firm employs OC units of factor Y and OD units of
factor X to produce 400 units of output. This is the optimum output which
the firm can get from the cost outlay of Q. In this figure any point below Q
on the price line AB is desirable as it shows lower cost, but it is not
attainable for producing 400 units of output. As regards points RS above
Q on iso -cost lines GH, EF, they show higher cost.
These are beyond the reach of the producer with CD outlay. Hence
point Q is the least cost p oint. It is the point which is the least cost factor
combination for producing 400 units of output with OC units of factor Y
and OD units of factor X. Point Q is the equilibrium of the producer.
At this point, the slope of the iso -quants equal to the slo pe of the
iso-cost line. The MRT of the two inputs equals their price ratio. Thus we
find that at point Q, the two conditions of producer's, equilibrium in the
choice of factor combinations, are satisfied.
(1) The iso -quant (IP) is convex the origin.
(2) At point Q, the slope of the iso -quant ΔY / ΔX(MTYS xy) is equal to
the slope of the iso -cost in Px / Py. The producer gets the optimum output
at least cost factor combination.
3.9 SUMMARY
1.Ineconomics, a production function gives the technological relation
between quantities of ph ysical inputs and quantities of output of goods.
2. A production function is said to be short -run when at least one factor
input cannot be changed during the period. In other terms, when not all
factors of production is variable then a production function is short -run,
and called short run production function. On the other hand, all the factor
inputs are variable in long -run production function. Long -run is defined as
the time period in which all factor inputs, that are included in production
function, can be changed.
3.This very famous Cobb -Douglas production function is a long -run
production function, and is the result of combined efforts of professor of
economics cum U.S. senator Paul Douglas and mathematician Charles
Cobb. Mathematically, the general C obb-Douglas production function is
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Q= F(L,K) = A K αLβwhere A, α,β>0
where, Q is output, αis output elasticity of capital, βis output elasticity of
labor, and A is productivity or total factor productivity measuring
productivity of production function or technology or factor inputs i n total.
4.CES stands for constant elasticity of substitution. This latest CES
production function is due to the joint effort of Arrow Chenery, Minhas
and Solow. This CES production function is more general production
function which yields the constant el asticity of factor substitution other
than 1.
5.The modern economists are using iso -quant, or "ISO" product curves
for determining the optimum factor combination to produce certain units
of a commodity at the least cost.
6.Aniso-quant map shows a set of iso-product curves. Each iso -quant
represents a different level of output. A higher iso -quant shows a higher
level of output and a lower iso -quant represents a lower level of output.
7. Properties of Iso -quants are:
i)An Iso -quant Slopes Downward from Le ft to Right
ii)An Iso -quant that Lies Above and to the Right of Another Represents a
Higher Output Level
iii)Iso-quants Cannot Cut Each Other
iv)Iso-quants are Convex to the Origin
v)Each Isoquant is Oval Shaped
8.An iso -cost line is also called outla y line or price line or fac tor cost line.
Itshows all the combinations of labor and capital that are available for a
given total cost to -the producer. Just as there are infinite number of iso-
quants, there are infinite number of iso -cost lines , one for every possible
level of a given total cost. The greater the total cost, the further from
origin is the iso -cost line.
9.Prof. R.G.D. Alien and J.R. Hicks introduced the concept of MRS
(marginal r ate of substitution) in the theory of demand. The similar
concept is used in the explanation of producers equilibrium and is named
asmarginal rate of technical substitution (MRTS). Itis"The rate at which
one factor can be substituted for another while h olding the level of output
constant".munotes.in

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10.Theleast cost combination or the optimum factor combination refers
to the combination of factors with which a firm can produce a specific
quantity of output at the lowest possible cost.
3.10 QUESTIONS
1. Explai n in brief the concept of Production function.
2. What are the different types of production function?
3. Write a note on Cobb -Douglas production function.
4. Discuss in brief Constant Elasticity of Substitution.
5. State and explain the properties of Iso -quant curve.
6. Explain the two approaches to derive Optimum Factor Combination.
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UNIT -3A
LAWS OF PRODUCTION AND COST
ANALYSIS
Unit Structure:
3A.0 Objectives
3A.1 Law ofVariable Proportions
3A.2 Assumptions
3A.3 Three Stages oftheLaw
3A.4 Condition orCauses ofApplicability
3A.5 Applicability oftheLaw ofVariable Proportions
3A.6 Postponement oftheLaw
3A.7 Law ofReturns toScale
3A.8 Economies of Scale
3A.9 Diseconomies of Scale
3A.10 Economies of Scale versus Economies of Scope
3A.11 What is Economies of Scope?
3A.12 Meaning ofExpansion Path
3A.13 Learning Curve
3A.14 Concept of Costs
3A.15 Concept of Production Costs
3A.16 Components of Economic Costs
3A.17 Classification ofCost According totheElement
3A.18 Long -RunCosts: ThePlanning Horizon
3A.19 TheShape oftheLac: Economies andDiseconomies ofScale
3A.20 Summary
3A.21 Question s
3A.0 OBJECTIVES
To familiar students with Concept of Law of variable proportions
To acquaint the students with Economies of Scale & Economies of
Scope
To understand the concept of Expansion path and Multiproduct firmmunotes.in

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To Study Cost reduction through experience -Learning curve
To understand the significance of Costs
3A.1 LAW OFVARIABLE PROPORTIONS
Law of Variable Proportions occupies an important place in
economic theory. This law is also known a s Law of Proportionality.
Keeping other factors fixed, the law explains the production function with
one factor variable. In the short run when output of a commodity is sought
to be increased, the law of variable proportions comes into operation.
Therefor e, when the number of one factor is increased or
decreased, while other factors are constant, the proportion between the
factors is altered. For instance, there are two factors of production viz.,
land and labour. Land is a fixed factor whereas labour is a variable factor.
Now, suppose we have a land measuring 5 hectares. We grow wheat on it
with the help of variable factor i.e., labour. Accordingly, the proportion
between land and labour will be 1: 5. If the number of laborers is
increased to 2, the new pr oportion between labour and land will be 2: 5.
Due to change in the proportion of factors there will also emerge a change
in total output at different rates. This tendency in the theory of production
called the Law of Variable Proportion.
Definitions: “Asthe proportion of the factor in a combination of factors is
increased after a point, first the marginal and then the average product of
that factor will diminish.” Benham
3A.2 ASSUMPTIONS
Law ofvariable proportions isbased onfollowing assumptions:
(i)Constant Technology:
The state of technology is assumed to be given and constant. If
there is an improvement in technology the production function will move
upward.
(ii)Factor Proportions areVariable:
The law assumes that factor proportions are varia ble. If factors of
production are to be combined in a fixed proportion, the law has no
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(iii)Homogeneous Factor Units:
The units of variable factor are homogeneous. Each unit is
identical in quality and amount with every other unit.
(iv)Short -Run:
The law operates in the short -run when it is not possible to vary all
factor inputs.
3A.2.1Explanation oftheLaw:
In order to understand the law of variable proportions we take the
example of agriculture. Suppose land and labour are the only two fac tors
of production.
Bykeeping land asafixed factor, theproduction ofvariable factor
i.e.,labour canbeshown with thehelp ofthefollowing table:
Table 3A.1
From the table 3A.1 it is clear that there are three stages of the law
of variable proportion. In the first stage average production increases as
there are more and more doses of labour and capital employed with fixed
factors (land). We see that t otal product, average product, and marginal
product increases but average product and marginal product increases up
to 40 units. Later on, both start decreasing because proportion of workers
to land was sufficient and land is not properly used. This is the end of the
first stage.
The second stage starts from where the first stage ends or where
AP=MP. In this stage, average product and marginal product start falling.
We should note that marginal product falls at a faster rate than the average
product. Here, total product increases at a diminishing rate. It is also
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The third stage begins where second stage ends. This starts from
8th unit. Here, marginal product is negative and total product falls but
average product is still positive. At this stage, any additional dose leads to
positive nuisance because additional dose leads to negative marginal
product.
3A.2.2Graphic Presentation:
In fig. 1, o n OX axis, we have measured number of labourers while
quantity of product is shown on OY axis. TP is total product curve. Up to
point ‘E’, total product is increasing at increasing rate. Between points E
and G it is increasing at the decreasing rate. Here marginal product has
started falling. At point ‘G’ i.e., when 7 units of labourers are employed,
total product is maximum while, marginal product is zero. Thereafter, it
begins to diminish corresponding to negative marginal product. In the
lower part of th e figure, MP is marginal product curve.
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Up to point ‘H’ marginal product increases. At point ‘H’, i.e.,
when 3 units of labourers are employed, it is maximum. After that,
marginal product begins to decrease. Before point ‘I’ marginal product
becomes zero at point C and it turns negative. AP curve represents average
product. Before point ‘I’, average product is less than marginal product. At
point ‘I’ average product is maximum. Up to point T, average product
increases but after that it starts to diminish.
3A.3 THREE STAGES OFTHE LAW
1.First Stage:
First stage starts from point ‘O’ and ends up to point F. At point F
average product is maximum a nd is equal to marginal product. In this
stage, total product increases initially at increasing rate up to point E.
between ‘E’ and ‘F’ it increases at diminishing rate. Similarly marginal
product also increases initially and reaches its maximum at point ‘ H’.
Later on, it begins to diminish and becomes equal to average product at
point T. In this stage, marginal product exceeds average product
(MP > AP).
2.Second Stage :
It begins from the point F. In this stage, total product increases at
diminishing rate and is at its maximum at point ‘G’ correspondingly
marginal product diminishes rapidly and becomes ‘zero’ at point ‘C’.
Average product is maximum at point ‘I’ and thereafter it begins to
decrease. In this stage, marginal product is less t han average product
(MP < AP).
3.Third Stage:
This stage begins beyond point ‘G’. Here total product starts
diminishing. Average product also declines. Marginal product turns
negative. Law of diminishing returns firmly manifests itself. In th is stage,
no firm will produce anything. This happens because marginal product of
the labour becomes negative. The employer will suffer losses by
employing more units of labourers. However, of the three stages, a firm
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InWhich Stage Rational Decision isPossible:
To make the things simple, let us suppose that, a is variable factor
and b is th e fixed factor. And a 1,a2,a3….are units of a and b 1b2b3……
are unit of b.
Stage I is characterized by increasing AP, so that the total product
must also be increasing. This means that the efficiency of the variable
factor of production is increasing i. e., output per unit of ‘a’ is increasing.
The efficiency of ‘b’, the fixed factor, is also increasing, since the total
product with ‘b’ 1is increasing.
The stage II is characterized by decreasing AP and a decreasing
MP, but with MP not negative. Thus, the efficiency of the variable factor
is falling, while the efficiency of b, the fixed factor, is increasing, since the
TP with ‘b’ 1continues to increase.
Finally, stage III is characterized by falling AP and MP, and
further by negative MP. Thus, the effici ency of both the fixed and variable
factor is decreasing.
Rational Decision:
Stage II becomes the relevant and important stage of production.
Production will not take place in either of the other two stages. It means
production will not take place in stag e III and stage I. Thus, a rational
producer will operate in stage II.
Suppose b were a free resource; i.e., it commanded no price. An
entrepreneur would want to achieve the greatest efficiency possible from
the factor for which he is paying, i.e., from f actor ‘a’. Thus, he would want
to produce where AP is maximum or at the boundary between stage I
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If on the other hand, “a” were the free resource, then he would
want to employ “b” to its most efficient point; this is the boundary
betwee n stage II and III.
Obviously, if both resources commanded a price, he would
produce somewhere in stage II. At what place in this stage production
takes place would depend upon the relative prices of ‘a’ and ‘b’.
3A.4 CONDI TION ORCAUSES OFAPPLICABILITY
There are many causes, which are responsible for the application
of the law of variable proportions.
They areasfollows:
1.Under Utilization ofFixed Factor:
In initial stage of production, fixed factors of production like land
or machine, is under -utilized. More units of variable factor, like labour,
are needed for its proper utilization. As a result of employment of
additional units of variable factors there is proper utilization of fixed
factor. In short, increasing returns to a factor begins to man ifest itself in
the first stage.
2.Fixed Factors ofProduction.
The foremost cause of the operation of this law is that some of the
factors of production are fixed during the short period. When the fixed
factor is used with variable factor, then its rati o compared to variable
factor falls. Production is the result of the co -operation of all factors.
When an additional unit of a variable factor has to produce with the help
of relatively fixed factor, then the marginal return of variable factor begins
to de cline.
3.Optimum Production:
After making the optimum use of a fixed factor, then the marginal
return of such variable factor begins to diminish. The simple reason is that
after the optimum use, the ratio of fixed and variable factors become
defective. L et us suppose a machine is a fixed factor of production. It is
put to optimum use when 4 labourers are employed on it. If 5 labourers are
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4.Imperfect Substitutes:
Mrs. Joan Robinson has put the argument that imperfect
substitution of factors is mainly responsible for the operation of the law of
diminishing returns. One factor cannot be used in place of the other factor.
After optimum use of fixed factors, variable factors are increased and the
amount of fixed factor could be increased by its substitutes.
Such a substitution would increase the production in the same
proportion as earlier. But in real practice factors are imperfect substitutes.
However, after the opt imum use of a fixed factor, it cannot be substituted
by another factor.
3A.5 APPLICABILITY OFTHE LAW OFVARIABLE
PROPORTIONS
The law of variable proportions is universal as it applies to all
fields of production. This law applies to any field of produc tion where
some factors are fixed and others are variable. That is why it is called the
law of universal application.
The main cause of application of this law is the fixity of any one
factor. Land, mines, fisheries, and house building etc. are not the on ly
examples of fixed factors. Machines, raw materials may also become fixed
in the short period. Therefore, this law holds good in all activities of
production etc. agriculture, mining, manufacturing industries.
1.Application toAgriculture:
With a view of raising agricultural production, labour and capital
can be increased to any extent but not the land, being fixed factor. Thus
when more and more units of variable factors like labour and capital are
applied to a fixed factor then their marginal product starts to diminish and
this law becomes operative.
2.Application toIndustries:
In order to increase production of manufactured goods, factors of
production has to be increased. It can be increased as desired for a long
period, being variable factors. T hus, law of increasing returns operates in
industries for a long period. But, this situation arises when additional units
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As a result, after a point, marginal produ ct increases less
proportionately than increase in the units of labour and capital. In this
way, the law is equally valid in industries.
3A.6 POSTPONEMENT OFTHE LAW
The postponement ofthelaw ofvariable proportions is
possible under following conditio ns:
(i)Improvement inTechnique ofProduction:
The operation of the law can be postponed in case variable factors
techniques of production are improved.
(ii)Perfect Substitute:
The law of variable proportion can also be postponed in case
factors of prod uction are made perfect substitutes i.e., when one factor can
be substituted for the other.
3A.7 LAW OFRETURNS TOSCALE
In the long run all factors of production are variable. No factor is
fixed. Accordingly, the scale of production can be changed by changing
the quantity of all factors of production.
Definition:
“The term returns to scale refers to the changes in output as all factors
change by the same proportion.” Koutsoyiannis
“Returns to scale relates to the behaviour of total output as all inpu ts are
varied and is a long run concept”. Leibhafsky
Returns toscale areofthefollowing three types:
1. Increasing Returns to scale.
2. Constant Returns to Scale
3. Diminishing Returns to Scale
Explanation:
In the long run, output can be increased by increasing all factors in the
same proportion. Generally, laws of returns to scale refer to an increase in
output due to increase in all factors in the same proportion. Such an
increase is called returns to scale.
Suppose, initially production function isasfollows:
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Now, if both the factors of production i.e., labour and capital are increased
in same proportion i.e., x, product function will be rewritten as.
itwillbeincreasing returns toscale. Returns toscale canbeshown with
thehelp oftable 3A.2
Showing different stages ofreturn toscale
The above stated table explains thefollowing three stages of
returns toscale:
1.Increasing Returns toScale:
Increasing returns to scale or diminishing cost refers to a situation
when all fa ctors of production are increased, output increases at a higher
rate. It means if all inputs are doubled, output will also increase at the
faster rate than double. Hence, it is said to be increasing returns to scale.
This increase is due to many reasons li ke division external economies of
scale. Increasing returns to scale can be illustrated with the help of a
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Fig.3A.2
In figure 3A.2 , OX axis represents increase in labour and capital
while OY axis shows increase in output. When labour and c apital
increases from Q to Q 1, output also increases from P to P 1which is higher
than the factors of production i.e. labour and capital.
2.Diminishing Returns toScale:
Diminishing returns or increasing costs refer to that production
situation, where if all the factors of production are increased in a given
proportion, output increases in a smaller proportion. It means, if inputs are
doubled, output will be less than doubled. If 20 percent increase in labour
and capital is followed by 10 percent increase in output, then it is an
instance of diminishing returns to scale. The main cause of the operation
of diminishing returns to scale is that internal and external economies are
less than internal and external diseconomies. It is clear from diagram
3A.3 .
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In this diagram 3A.3 , diminishing returns to scale has been shown.
On OX axis, labour and capital are given while on OY axis, output. When
factors of production increase from Q to Q 1(more quantity) but as a result
increase in output, i.e. P to P 1is less. We see that increase in factors of
production is more and increase in production is comparatively less, thus
diminishing returns to scale apply.
3.Constant Returns toScale:
Constant returns to scale or constant cost refers to the production
situation in which output increases exactly in the same proportion in
which factors of production are increased. In simple terms, if factors of
production are doubled output will also be doubled.
In this case internal and external economies are exactly equ al to
internal and external diseconomies. This situation arises when after
reaching a certain level of production, economies of scale are balanced by
diseconomies of scale. This is known as homogeneous production
function. Cobb -Douglas linear homogenous pr oduction function is a good
example of this k ind. This is shown in diagram 3A.4. In figure 3A.4 ,w e
see that increase in factors of production i.e. labour and capital are equal
to the proportion of output increase. Therefore, the result is constant
returns to scale.
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Check your progress:
1. State the Law of variable proportions.
2. Distinguish between First, Second and Third stage of Law of variable
proportion.
3. What are the conditions / causes of Law of variable proportion.
4. State La w of Returns to scale.
____________________________________________________________
____________________________________________________________
____________________________________________________________
_____________________________________________________ _______
____________________________________________________________
3A.8 ECONOMIES OF SCALE
Economies of scale are cost reductions that occur when companies
increase production. The fixed costs, like administration, are spread over
more units of producti on. Sometimes the company can negotiate to lower
itsvariable costs as well. Governments, non -profits, and even individuals
can also benefit from economies of scale. It occurs whenever an entity
produces more, becomes more efficient, and lowers costs as a result.
Economies of scale not only benefit the organization. Consumers
can enjoy lower prices. The economy grows as lower prices stimulate
increased demand. Economies of scale give a competitive advantage to
large entities over smaller ones. The larger t he business, non -profit, or
government, the lower its per -unit costs.
Key Takeaways
Economies of scale occur when a company’s production increases,
leading to lower fixed costs.
Internal economies of scale can be because of technical improvements,
manager ial efficiency, financial ability, monopsony power, or access
to large networks.
External economies are ones where companies can influence economic
priorities, often leading to preferential treatment by governments.
Diseconomies of scale can occur when a company becomes too big,
lowering its production.
3A.8.1Types
There are two main types of economies of scale: internal and
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are internal to the company. External economies depend up on external
factors. These factors include the industry, geographic location, or
government.
3A.8.2Internal Economies of Scale
Internal economies result from a larger volume of production. We
can typically see them in large organizations. For example, l arge
companies can buy in bulk. This economy lowers the cost per unit of the
materials they need to make their products. They can use the savings to
increase profits. Or they can pass the savings to consumers and compete
on price.
There are five main type s of internal economies of scale.
Technical economies of scale result from efficiencies in the
production process itself. Manufacturing costs fall 70% to 90% every time
the business doubles its output. Larger companies can take advantage of
more efficient equipment.
For example, data mining software allows the firm to target
profitable market niches. Large shipping companies cut costs by using
super -tankers. Finally, large companies achieve technical economies of
scale because they learn by doing. They’re far ahead of their smaller
competition on the learning curve.
Monopsony power is when a company buys so much of a product
that it can reduce its per -unit costs. For example, Wal -Mart's "everyday
low prices" are due to its huge buying power.
Managerial economies of scale occur when large firms can afford
specialists. They more effectively manage particular areas of the company.
For example, a seasoned sales executive has the skill and experience to get
the big orders. They demand a high salary, but they'r e worth it.
Financial economies of scale mean the company has cheaper
access to capital. A larger company can get funded from the stock market
with an initial public offering. Big firms have higher credit ratings. As a
result, they benefit from lower inte rest rates on their bonds.
Network economies of scale occur primarily in online businesses.
It costs almost nothing to support each additional customer with existing
infrastructure. So, any revenue from the new customer is all profit for the
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3A.8.3External Economies of Scale
A company has external economies of scale if its size creates
preferential treatment. That most often occurs with governments.
For example, a state often reduces taxes to attract the companies
thatprovide the most jobs. Big real estate developers convince cities to
build roads to support their buildings. This government building saves
developers from paying those costs. Large companies can also take
advantage of joint research with universities. Th is partnership lowers
research expenses for these companies. Small companies don't have
theleverage to benefit from external economies of scale, but they can
band together.
Small companies can cluster similar businesses in a small area.
That allows them to take advantage of geographic economies of scale. For
example, artist lofts, galleries, and restaurants benefit by being together in
a downtown art district.
3A.9 DISECONOMIES OF SCALE
Sometimes a company chases economies of scale so much that it
becomes too large. This overgrowth is called a diseconomy of scale.
For example, it might take longer to make decisions, making the
company less flexible. Miscommunication could occur, especially if the
company becomes global. Acquiring new companies could re sult in a
clash of corporate cultures. This clash will slow progress if they don't
learn to manage cultural diversity.
3A.9.1How to Make Economies of Scale Work for You
You don't have to be a corporation to benefit from economies of
scale. Think of it li ke how larger families typically buy in bulk. Each box
of detergent costs less per wash because you can buy it in bulk. The
manufacturer saves on packaging and distribution. It then passes the
savings onto you. Bulk is also cheaper for you because you make fewer
trips to the store.
3A.10 ECONOMIES OF SCALE VERSUS ECONOMIES
OF SCOPE
Economies of scope occur when a company branches out into
multiple product lines. They benefit by combining complementary
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For example, most newspapers diversified into similar product
lines, such as magazines and online news. This expansion diversified their
revenue away from declining newspaper sales. Their advertising sales
teams could sell ads in all three product lines.
It's easy to confuse economies of scale with economies of scope
because they are both found in larger companies. Just remember that
economies of scale apply to one product line. Economies of scope refer to
combining efficiencies from many product lines.
3A.11 WHAT IS ECONOMIES OF SCOPE?
Economies of scope is an economic concept that the unit cost to
produce a product will decline as the variety of products increases. That is,
the more different -but-similar goods you produce, the lower the total c ost
to produce each one.
For example, let’s say that you’re a shoe manufacturer. You
produce men’s and women’s sneakers. Adding a children’s line of
sneakers would increase economies of scope because you can use the
same production equipment, supplies, st orage, and distribution channels to
make a new line of products. That will further reduce the cost of
production on all your shoes.
The cost to produce all three of your different lines is lower than if
three different companies each produced a line of me n’s shoes, a line of
women’s shoes, and a children’s line. Because you can extend the use of
your resources to make more products to be sold to your same target
market, you can continue to drive costs down.
3A.12 MEANING OFEXPANSION PATH
Ineconomics, anexpansion path (also called a scale line )i sa
curve in a graph with quantities of two inputs, typically physical
capital andlabour, plotted on the axes. The path connects optimal input
combinations as the scale of production expands
.https://en.wikipedia.org/wiki/Expansion_path -cite_note -Hirschey -2A
producer seeking to produce a given number of units of a product in the
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Economists Alfred Stonier and Douglas Hague defined “expansion
path” as "that line which reflects the least –costmethod of producing
different levels of output, when factor prices remain constant. The points
on an expansion path occur where the firm's iso -cost curves, each showing
fixed total input cost, and its iso -quants, each showing a particular level of
output, are tangent; each tangency point determines the firm's condi tional
factor demands. As a producer's level of output increases, the firm moves
from one of these tangency points to the next; the curve joining the
tangency points is called the expansion path .
If an expansion path forms a straight line from the origin, the
production technology is considered homothetic (or homoethetic).In this
case, the ratio of input usages is always the same regardless of the level of
output, and the inputs can be expanded proportionately so as to maintain
this optimal ratio as the le vel of output expands. A Cobb –Douglas
production function is an example of a production function that has an
expansion path which is a straight line through the origin.
We know that the production function of the firm
q=f ( x , y ) (8.21)
gives us the isoquant map of the firm, one isoquant (IQ) for each particular
level of output, and the cost equation of the firm
C=r Xx+r Yy (8.54)
gives us the family of parallel iso -cost lines (ICLs), given the prices of the
inputs r Xand r Y, one ICL for one particular level of cost. The IQ -map and
the family of ICLs have been given in Fig. 8.14. If we now join the point
of origin 0 and the points of tangency, E 1,E2,E3, etc., between the IQs and
the ICLs by a curve, then this curve (OK in Fig. 3A.5 ) would give us what
is known as the expansion path of the firm.
The expansion path is so called because if the firm decides to
expand its operations, it would have to move along this path. Let us note
that the firm may expand in two ways.
First, it may want to expand by successively increasing its level of
cost or its expenditure on the inputs X and Y, i.e., by using more and more
of inputs, and, consequently, by producing more of its output.
Second, the firm may decide to ex pand by increasing its level of
output per period. This the firm may do by increasing the expenditure on
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The two approaches to expansion apparently appear to be the
same, for both involve an increase in ex penditure. However, there is a
fundamental difference. In the first case, decision is taken initially at the
point of cost. Cost levels are made higher and higher and then efforts are
made to maximize the level of output subject to the cost constraint.
Fig.3A.5 Theexpansion path ofafirm
On the other hand, in the second case, decision -making occurs
initially and directly at the point of output. Here the firm first decides to
produce more of output and then efforts are made to produce the output at
theminimum possible cost.
3A.13 LEARNING CURVE
A learning curve is a concept that graphically depicts the
relationship between the cost and output over a defined period of time,
normally to represent the repetitive task of an employee or worker. The
learni ng curve was first described by psychologist Hermann Ebbinghaus
in 1885 and is used as a way to measure production efficiency and
toforecast costs.
In the visual representation of a learning curve, a steeper slope
indicates initial learning translates in to higher cost savings, and
subsequent learnings result in increasingly slower, more difficult cost
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KEY TAKEAWAYS
The learning curve is a visual representation of how long it takes to
acquire new skills or knowledge.
In business, the slope of t he learning curve represents the rate in which
learning new skills translates into cost savings for a company.
The steeper the slope of the learning curve, the higher the cost savings
per unit of output.
3A.13 .1Understanding Learning Curves
The learning curve also is referred to as the experience curve, the
cost curve, the efficiency curve, or the productivity curve. This is because
the learning curve provides measurement and insight into all the above
aspects of a company. The idea behind this is that an y employee,
regardless of position, takes time to learn how to carry out a specific task
or duty. The amount of time needed to produce the associated output is
high. Then, as the task is repeated, the employee learns how to complete it
quickly, and that re duces the amount of time needed for a unit of output.
That is why the learning curve is downward sloping in the beginning with
a flat slope toward the end, with the cost per unit depicted on the Y -axis
and total output on the X -axis. As learning increases, it decreases the cost
per unit of output initially before flattening out, as it becomes harder to
increase the efficiencies gained through learning.
3A.13 .2Benefits of Using the Learning Curve
Companies know how much an employee earns per hour and can
derive the cost of producing a single unit of output based on the number of
hours needed. A well -placed employee who is set up for success should
decrease the company's costs per unit of output over time. Businesses can
use the learning curve to conduct pr oduction planning, cost forecasting,
andlogistics schedules.
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The learning curve does a good job of depicting the cost per unit of
output over time.
The slope of the learning curve represents the rate in which
learning translates into cost savings for a company. The steeper the slope,
the higher the cost savings per unit of output. This standard learning curve
is known as the 80% learning curve. It shows that for every doubling of a
company's output, the cost of the new output is 80% of the prior output.
As output increases, it becomes harder and harder to double a company's
previous output, depicted using the slope of the curve, which means cost
savings slow over time.
Check your progress:
1. State the various types of Economies of scale.
2. Explain the concept of Diseconomies of scale.
3. Write a note on Economies of scope.
4. Explain the meaning of Expansion path.
5. Derive a Learning curve.
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3A.14 CONCEPT OF COSTS
1. Accounting costs
Accounti ng costs are those for which the entrepreneur pays direct
cash for procuring resources for production. These include costs of the price
paid for raw materials and machines, wages paid to workers, electricity
charges, the cost incurred in hiring or purchasi ng a building or plot, etc.
Accounting costs are treated as expenses. Chartered accountants record them
in financial statements.
2. Economic costs
There are certain costs that accounting costs disregard. These include
money which the entrepreneur forgoes but would have earned had he
invested his time, efforts and investments in other ventures. For example, the
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Similarly, potential returns on thecapital he employed in his business
instead of giving it to others, the output generated by his resources which he
could have used for others’ benefits, etc. are other examples
ofeconomic costs.
Economic costs help the entrepreneur calculate supernor malprofits ,
i.e. profits he would earn above the normal profits by investing in ventures
other than his.
3.Explicit andImplicit orImputed Costs:
Explicit costs refer to those which fall under actual or business
costs entered in the books of accounts. The payments for wages and
salaries, materials, license fee, insurance premium, depreciation charges
are the examples of explicit costs. These costs involve cash payments and
are recorded in normal accounting practices.
In contrast with these costs, there are not certain other costs which
do not take the form of cash outlays, nor do they appear in the accounting
system. Such costs are known as implicit or imputed costs. Implicit costs
may be defined as the earning expected from the second best alternative
use of resources. For instance, suppose an entrepreneur does not utilize his
services in his own business and works as a manager in some other firm
on a salary basis.
If he starts his own business, he foregoes his salary as manager.
This loss of salary is the opportunity costs of income from his own
business. This is an implicit cost of his own business; implicit, because the
entrepreneur suffers the loss, but does not charge it as the explicit cost of
his own business. Thus, implicit wages, rent and inter est are the highest
wages, rents and interest which owner’s labour, building and capital can
respectively earn from their second best use.
Implicit costs are not taken into account while calculating the loss
or gains of the business, but they form an impo rtant consideration in
whether or not a factor would remain in its present occupation. The
explicit and implicit costs together make the economic cost.
4 . Outlay costs
The actual expenses incurred by the entrepreneur in employing
inputs are called outlay costs .T h e s ei n c l u d ec o s t so np a y m e n to fw a g e s ,r e n t ,
electricity or fuel charges, raw materials, etc. We have to treat them are
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5 . Opportunity costs
Opportunity costs are incomes from the next best alternative that is
foregone when the entrepreneur makes certain choices.
For example, the entrepreneur could have earned a salary had he
worked for others instead of spending time on his own business. These costs
calculate the missed opportunity and calculate income that w e can earn by
following some other policy.
6 . Direct costs
Direct costs are related to a specific process or product. They are also
called traceable costs as we can directly trace them to a particular activity,
product or process.
They can vary with cha nges in the activity or product. Examples of
direct costs include manufacturing costs relating to production, customer
acquisition costs pertaining to sales, etc.
7. Indirect costs
Indirect costs, or untraceable costs, are those which do not directly
relate to a specific activity or component of the business. For example, an
increase in charges of electricity or taxes payable on income. Although we
cannot trace indirect costs, they are important because they affect overall
profitability.
8 . Incremental c osts
These costs are incurred when the business makes a policy decision.
For example, change of product line, acquisition of new customers, upgrade
of machinery to increase output are incremental costs.
9 . Sunk costs
Suck costs are costs which the entrep reneur has already incurred and
he cannot recover them again now. These include money spent on
advertising, conducting research, and acquiring machinery.
10 . Private costs
These costs are incurred by the business in furtherance of its own
objectives. Ent repreneurs spend them for their own private and business
interests. For example, costs of manufacturing ,p r o d u c t i o n ,s a l e ,a d v e r t i s i n g ,
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11. Social costs
As the name suggests, it is the society that bears social costs for
private interests and expen ses of the business. These include social resources
for which the firm does not incur expenses, like atmosphere, water resources
and environmental pollution.
3A.15 CONCEPT OF PRODUCTION COSTS
1. Fixed costs
Fixed costs are those which do not change with the volume of output.
The business incurs them regardless of their level of production. Examples
of these include payment of rent, taxes, interest on a loan, etc.
2. Variable costs
These costs will vary depending upon the output that the business
generat es. Less production will cost fewer expenses, and vice versa, the
business will pay more when its production is greater. Expenses on the
purchase of raw material and payment of wages are examples of variable
costs.
3A.13.1 Total, Average andMarginal Costs:
Total costrepresents the value of the total resource requirement
for the production of goods and services. It refers to the total outlays of
money expenditure, both explicit and implicit, on the resources used to
produce a given level of output. It inc ludes both fixed and variable costs.
The total cost for a given output is given by the cost function.
Average cost:
Average cost (AC) is of statistical nature, it is not actual cost. It is
obtained by dividing the total cost (TC) by the total output (Q), i.e.
AC = TC / Q = average cost
Marginal cost:
Marginal cost is the addition to the total cost on account of
producing an additional unit of the product. Or, marginal cost is the cost of
marginal unit produced. Given the cost function, it may be defined a s
MC = TC/ Q
These cost concepts are discussed in detail in the following
section. Total, average and marginal cost concepts are used in economic
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Total costs
Fig.3A.6
Total cost (TC) = Variable cost (VC) + fixed costs (FC)
3A.13 .2Relation Between Marginal Cost(MC) and Average
Cost(AC): The relationship between MC and AC may be explained as
follows:
1.When MC falls, AC also falls but at lower rate than that of MC. So
long as MC curve lies below the AC curve , the AC curve is falling.
2.When MC rises, AC also rises but at lower rate than that of MC. That
is, when MC curve lies above AC curve, the AC curve is rising.
3.MC intersects AC at its minimum. That is, MC = AC at its minimum.
3A.13 .3Short -Run andLong -RunCosts:
Short -run and long -run cost concepts are related to variable and
fixed costs respectively, and often marked in economic analysis
interchangeably. Short -run costs are the costs which vary with the
variation in output, the size of the firm remainin g the same. In other
words, short -run costs are the same as variable costs. Long -run costs, on
the other hand, are the costs which are incurred on the fixed assets like
plant, building, machinery, etc. Such costs have long -run implication in
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Long -run costs are, by implication, the same as fixed costs. In the
long-run, however, even the fixed costs become variable costs as the size
of the firm or scale of production increases. Broadly sp eaking, ‘the short -
run costs are those associated with variables in the utilization of fixed
plant or other facilities whereas long -run costs are associated with the
changes in the size and kind of plant.’
Average Cost Curves
ATC (Average Total Cost) = To tal Cost / quantity
AVC (Average Variable Cost) = Variable cost / quantity
MC = Marginal cost.
AFC (Average Fixed Cost) = Fixed cost / quantity
Fig.3A.7Short runaverage andmarginal costcurves
3A.16 COMPONENTS OF ECONOMIC COSTS
Economic cost takes into account costs attributed to the alternative
chosen and costs specific to the forgone opportunity. Before making
economic decisions, there are a series of components of economic costs
that a firm will take into consideration. These components include:
Total cost (TC): total cost equals total fixed cost plus total variable
costs (TC = TFC + TVC).
Variable cost (VC): the cost paid to the variable input. Inputs include
labour, capital, materials, power, land, and buildings. Variable input is
traditionall y assumed to be labour.
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Fixed cost (FC): the costs of the fixed assets (those that do not vary
with production).
Total fixed cost (TFC): same as fixed cost.
Average cost (AC): total costs divided by output (AC = TFC/q +
TVC/q).
Average fixed cost (AFC): the fixed costs divided by output (AFC =
TFC/q). The average fixed cost function continuously declines as
production increases.
Average variable cost (AVC): variable costs divided by output (AVC
= TVC/q). Th e average variable cost curve is normally U -shaped. It
lies below the average cost curve, starting to the right of the y axis.
Marginal cost (MC): the change in the total cost when the quantity
produced changes by one unit.
Cost curves: a graph of the cost s of production as a function of total
quantity produced. In a free market economy, firms use cost curves to
find the optimal point of production (to minimize cost). Maximizing
firms use the curves to decide output quantities to achieve production
goals.
Table 3A.3
Short -run cost Schedules of a hypothetical firm
3A.17 CLASSIFICATION OFCOST ACCORDING TO
THE ELEMENT
In according to element cost can be divided into two main
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Direct cost:
It is such a cost that is able to mark directly any particular cost
such as raw materials, labor included operating expenses and some other
costs are belongs to the direct cost. These costs are bind in a unit. For
example, we can say a total cost of an ad vertisement for several products.
The direct cost has some subcategories.
Direct element: Direct element refers to that material which is related
all of the finished product. This material is a part to complete any
product. It can have imposed convenientl y on the particular product.
The purchased and upcoming requisite products are including in direct
element. As like, all kinds of initial packing material.
Direct labour: Direct labour means the paid salary to the employee
who is directly engaged in manufa cturing, handling and processing a
product. Actually, they are responsible for the observation and
maintenance of the product also.
Direct expense: Which cost is directly related to any particular
expenses is called direct expense. If a company needs to bu y some
specific product, equipment or tools are the examples of direct
expense.
Indirect cost:
Indirect cost means the opposite side of direct cost. Which cost is
related to a unit or department and can’t trace for any specific product
is called indirect cost. The indirect cost has also some subcategories.
Indirect element: Some example of indirect materials is cleaning
chemicals, small tools, glue, and maintenance work. Fuel etc. These
element costs are incurred as a unit.
Indirect labour: Indirect labour is covering the supervisors and the
inspector’s salary. The worker of cleaner and storekeeper wages is also
including in the indirect labour.
Indirect expenses: Indirect expenses are house rent, hospital service,
lighting, insurance, and welfare trust.
Indirect cost and the overhead cost is often the same. It follows the
indirect labor cost formula.
Factory overheads:
It is related to all kinds of indirect costs like manufacturing products
and time keeper’s salary.
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This overhead is included with advertising expense and packing
materials costs such as free advertising, marketing on the field.
Administration andoffice overhead:
Administrative expenses is an expense of office works related
expenses such as office lightin g, rent welfare trust are including here.
3A.17.1 Cost classification according tofunction:
Cost is classified by the following categories. The main four
categories of functional costs are given below -
Prime cost: Prime cost is the adjustment of the direc t material, direct
labour, and direct costs. It is actually the result of these three elements.
Product cost: It means the factory cost with administrative and office
overheads
Factory cost: Factory cost is also known as work cost. It is combined
with work cost and work expenses
3A.17.2 Cost classifications depending onbehaviour:
By behavior or variability cost is classified as Variable cost, Fixed
cost and Mixed cost which is explained below.
Variable cost: Variable cost is such a cost which proportion i s
changing with the amount of production. Such as direct material and
changeable costs
Fixed cost: This cost won’t change with the proportion of production.
It is maximum time fixed. But it is notable that this cost may be
changed after a long time. For ex ample, office rent, insurance, and
hospital cost.
Mixed cost: Mixed cost can change overall but not with the proportion
of production. More changeable cost is count under a Mixed cost. The
example of a mixed cost is electricity expenses.
3A.17 .3Cost classification according torelevance:
Relevance base cost is mainly divided into five categories which
are given below;
Relevant cost: Which cost can be by making a new decision is called
relevant cost. Occasionally there may have many relevant costs. This
cost is not fixed from before.
Opportunity cost: Opportunity cost is the system of getting some
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and time etc. Someone can rent his office for another purpose of
advantages. Moreover, the y can rent their other things also. It is
actually an extra benefit for a company.
Standard cost: Standard cost is fixed from the previous experience. It
was fixed according to the specific budget, the volume of an industry.
The actual cost is also include d with this cost.
Controllable cost: Which cost can be controlled by management is
called controllable cost. The manager can control some cost.
Sunk cost: It is known as a historical cost. Sunk cost effect is most
important for a company. It is such a cost which is already lost and
can’t be undone anymore. If a company is paid their monthly rent than
we can say this rent cost is sunk cost.
Classification ofcostaccording tomanagement:
These costs are mainly divided into two categories; Manufacturing
cost and Non -manufacturing cost given are given below;
Manufacturing cost: Manufacturing cost refers to the total cost of a
product from the raw materials to finish the product. It is mainly the
combination of direct material cost, labour cost, and manufactur ing
overheads.
Non-manufacturing cost: In order, the rules of GAAP Non -
manufacturing cost are not actual product cost. It is a part of the
company’s income statement.
A proper knowledge of classifications of costs mandatory for
increasing development of a company perfectly. Moreover, the accounting
students must have to clear idea about it.
Check your progress:
1. State various concepts of costs.
2. Distinguish between Fixed cost and variable cost.
3. Explain the concept of Economic cost.
4. Distinguish b etween Direct cost and Indirect cost.
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3A.18 LONG -RUNCOSTS: THE PLANNING HORIZON
We may recall from our discussion of produc tion theory that the
long run does not refer to ‘some date in the future. Instea d, the long run
simply refers to a period of time during which all inputs can be varied.
Therefore, a decision has to be made by the owner and/or manager
of the firm about the scale of operation, that is, the size of the firm. In
order to be able to make this decision the manager must have knowledge
about the cost of producing each relevant level of output. We shall now
discover how to determine these long -run costs.’
3A.18.1Derivation ofCost Schedules from aProduction Function:
For the sake of analysi s, we may assume that the firm’s level of
usage of the inputs does not affect the input (factor) prices. We also
assume that the firm’s manager has already evaluated the production func -
tion for each level of output in the feasible range and has derived an
expansion path.
For the sake of analytical simplicity, we may assume that the firm
uses only two variable factors, labour and capital, that cost Rs. 5 and Rs.
10 per unit, respectively.
The characteristics of a derived expansion path are shown in
Column s 1, 2 and 3 of Table 14.4. In column (1) we see seven output
levels and in Columns (2) and (3) we see the optimal combinations of
labour and capital respectively for each level of output, at the existing
factor prices.
These combinations enable us to loc ate seven points on the expansion
path.
Column (4) shows the total cost of producing each level of output
at the lowest possible cost. For example, for producing 300 units of
output, the least cost combination of inputs is 20 units of labour and 10 of
capital. At existing factor prices, the total cost is Rs. 200. Here, Column
(4) is a least -cost schedule for various levels of production.
In Column (5), we show average cost which is obtained by
dividing total cost figures of Column (4) by the corresponding output
figures of Column (1). Thus, when output is 100, average cost is Rs.munotes.in

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120/100 = Rs. 1.20. All other figures of Column (5) are derived in a
similar way.
From column (5) we derive an important characteristic of long -run
average cost: average cost fir st declines, reaches a minimum, then rises, as
in the short -run. In Column (6) we show long -run marginal cost figures.
Each such figure is arrived at by dividing change in total cost by
change in output. For example, when output increases from Rs. 100 to Rs.
200, the total cost increases from Rs. 120 to Rs. 140. Therefore, marginal
cost (per unit) is Rs. 20/100 = Re. 0.20. Similarly, when output increases
from 600 to 700 units, MC per unit is 720 -560/100 =160/100 =1.60
Column (6) depicts the behaviour of per unit MC: marginal cost
first decreases then increases, as in the short run.
We may now show the relationship between the expansion path
and long -run cost graphically. In Fig. 3A.8 two inputs, K and L, are
measured along the two axes. The fixed factor price ratio is represented by
the slope of the iso -cost lines I 1I’1,l2l’2and so on. Finally, the known
production function gives us the iso -quant map, represented by Q 1,Q2and
so forth.
Fig. 3A.8 The expansion path and long -run cost
From our earlier discussion of long -run produc tion function we
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will choose the least cost combin ations of producing each level of output.
In Fig. 3A.8 , we see that the locus of all such combinations is expansion
path OP’ B’R’S’.Given the factor -price ratio and the production func tion
(which is determined by the state of technol ogy), the expansion p ath
shows the combinations of inputs that enables the firm to produce each
level of output at the lowest cost.
Table 3A.4
Derivation long -run cost schedules
We may now relate this expansion path to a long -run to tal cost
(LRTC) curve. Fig. 3A.9 shows th e ‘least cost curve’ associated with
expansion path in Fig. 3A. 8. This least cost curve is the long -run to tal cost
curve. Points P,B,R and S are associated with points P’, B’, R’ and S’ on
the expansion path. For example, in Fig. 3A.8 the least cost combi nation
of inputs that can produce Q 1is K 1units of capital and L 1units of labour.
Thus, in Fig. 3A.9 , minimum pos sible cost of producing Q 1units of output
is TC 1, which is K 1+w L 1, i.e., the price of capital (or the rate of interest)
times K 1, plus t he price of labour (or the wage rate) times L 1. Every other
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Fig.3A.9 long -run total cost curve
Since the long r un permits capital -labour substi tution, the firm may
choose different combinations of these two inputs to produce different
levels of output. Thus, totally different production processes may be used
to produce (say) Q 1and Q 2units of output at the lowes t attainable cost.
On the basis of this diagram we may suggest a definition of the
long run total cost. The time period during which even/thing (except factor
prices and the state of technology or art of production) is variable is called
the long run and t he associated curve that shows the minimum cost of
producing each level of output is called the long -run total cost curve.
The shape of the long -run total cost (LRTC) cur ve depends on two
factors: the production func tion and the existing factor prices. Table 14.4
and Fig. 3A.9 reflect two of the commonly assumed char acteristics of
long-run total costs. First, costs and output are directly related; that is, the
LRTC curve has a positive slope. But, since there is no fixed cost in the
long run, the long run total cost curve starts from the origin.
Another characteristic of LRTC is that costs first increase at a
decreasing rate (until point B in Fig. 3A.9 ), and an increasing rate
thereafter. Since the slope of the total cost curve measures marginal cost,
the implication is that long -run marginal cost first decreases and then
increases. It may be added that all implicit costs of production are
included in the LRTC curve.
3A.18.2 Long -Run Average andMarginal Costs:
We turn now to distinguish between long run average and marginal
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Long -run average cost is arrived at by dividing the total cost of
producing a particular output by the number of units produced:
LRTC= LRTC/Q
Long -run marginal cost is the extra total cost of producing an
additional unit of output when all inputs are optimally adjusted:
LRTC= ∆ LRTC /∆Q
It, therefore, measures the change in total cost per unit of output as
the firm moves along the long run total cost curve (or the expansion path).
Fig. 14.8 illustrates typical long -run aver age and marginal cost curves.
They have essentially the same shape and relation to each other as in the
short run. Long -run average cost first declines, reaches a min imum (at
Q2in Fig. 3A.9 ), then increases. Long -run marginal cost first declines,
reaches minimum at a lower output than that associated with minimum av -
erage cost (Q 1in Fig. 3A.9 ), and increases thereafter.
The marginal cost intersects the average cost curve at its lowest
point (L in Fig. 3A.9 ) as in the short -run. The reason is also the sa me. The
reason has been aptly summarized by Maurice and Smithson thus: “When
marginal cost is less than average cost, each additional unit produced adds
less than average cost to total cost; so average cost must decrease.
When marginal cost is greater tha n average cost, each ad ditional
unit of the good produced adds more than average cost to total cost; so
average cost must be increasing over this range of output. Thus marginal
cost must be equal to average cost when average cost is at its minimum”.
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3A.19 THE SHAPE OFTHE LAC: ECONOMIES AND
DISECONOM IESOFSCALE
The shape of the long -run average cost depends on certain
advantages and disadvantages associated with large scale production.
These are known as economies and diseconomies of scale.
Average Cost intheLong Run: Smooth Envelope Case:
We know that in the short -run the firm has a fixed plant and it has
a short run U -shaped cost curve SAC. If a new and larger plant is built, the
new SAC will be d rawn further to the right.
We as sume that the firm is still in the planning stage and yet to
undertake any fixed commitment. It can now draw all possible different U -
shaped SAC curves, from which to choose one SAC for each specified
level of output that promises the lowest cost. As out put increases, the firm
moves to a new SAC curve.
In the long run, the firm can change the size of the plant. Starting
from zero output level, succes sively larger plants typically have lower and
lower ATC up to some output level and then successively higher ATC
curves beyond. The three representative ATC curves associated with the
three successively larger plants are shown in Fig. 3A.11(a).
Fig 3A. 11(a) Long run AC
Plant I is the best plant for output lev els less than 900 units
because its AC curve is the lowest to the left of point a. Plant II is the best
plant size for output levels between 900 to 2,000 units, because its AC
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foroutput levels greater than 2,000 units, since its AC curve is the lowest
beyond point b.
If these are only three possible plant sizes, the long run ATC curve
will consist of the segments of Plant I’s AC curve up to point a, the
segment of plant II’s AC cu rve between points a and b, and the segment of
Plant Ill’s AC curve from point of b and so on. The thick LAC is
composed of the three lowest branches of SACs. This is why the LAC is
called the envelope curve.
Fig. 3A.11(b) smooth envelope Curve
Fig.3A.11(b) is the smooth envelope case. Writes Samuelson: “In
the long run, a firm can choose its best plant sizes and its lower envelope
curve.” Since there is an infinite number of choices, we get LAC as a
smooth envelope. And, as in the short -run, we can derive LMC from LAC,
and LMC emerges from the minimum point of LAC with a smoother slope
than the SMC curve.
3A.20 SUMMARY
1.Keeping other f actors fixed, the L awof Variable Proportions explains
the production function with one factor variable. In the short run when
output of a commodity is sought to be increased, the law of variable
proportions comes into operation.
2.There are many causes, which are res ponsible for the application of the
law of variable proportions.
i)Under Utilization ofFixed Factor
ii)Fixed Factors ofProduction
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3.In the long run, output can be increased by increasing all factors in t he
same proportion. Generally, laws of returns to scale refer to an increase in
output due to increase in all factors in the same proportion. Such an
increase is called returns to scale.
4.Economies of scale occur when a company’s production increases,
leading to lower fixed costs.
5.Internal economies of scale can be because of technical improvements,
managerial efficiency, financial ability, monopsony power, or access to
large networks.
6.External economies are ones where companies can influence econo mic
priorities, often leading to preferential treatment by governments.
7.Diseconomies of scale can occur when a company becomes too big,
lowering its production.
8.Economies of scope occur when a company branches out into multiple
product lines. They b enefit by combining complementary business
functions, product lines, or manufacturing processes.
9.Ineconomics, an expansion path (also called a scale line) is a curve in a
graph with quantities of two inputs, typically physical capital andlabour,
plotted on the axes. The path connects optimal input combinations as the
scale of production expands .
10.The learning curve is a visual representation of how long it takes to
acquire new skills or knowledge.
11.In business, the slope of the learning curve rep resents the rate in which
learning new skills translates into cost savings for a company.
12.The steeper the slope of the learning curve, the higher the cost savings
per unit of output.
13.Short -run and long -run cost concepts are related to variab le and fixed
costs respectively. Short -run costs are the costs which vary with the
variation in output, the size of the firm remaining the same. In other
words, short -run costs are the same as variable costs. Long -run costs, on
the other hand, are the costs which are incurred on the fixed assets like
plant, building, machinery, etc.
14.Economic cost takes into account costs attributed to the alternative
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economic decisions, there are a series of c omponents of economic costs
that a firm will take into consideration.
15.The shape of the long -run average cost depends on certain advantages
and disadvantages associated with large scale production. These are
known as economies and diseconomies of scale.
3A.21 QUESTIONS
1. State and explain the Law of Variable proportions.
2. What are the conditions / causes responsible for the applicability of Law
of Variable proportions?
3. State and explain the Law of Returns to scale.
4. Differentiate between Inte rnal Economies and Internal Diseconomies of
scale.
5. Discuss various External economies of scale.
6. Write notes on the following:
a) Economies of scope
b) Expansion path
c) Learning curve
7. Differentiate between the following:
a) Accounting cost and Eco nomic cost
b) Fixed cost and Variable costs
c) Short run and Long run costs
d) Direct and Indirect costs
e) Implicit and Explicit costs
f) Incremental and Sunk costs
g) Private and Social costs
h) Average and Marginal costs
8. State and explain all short r un cost curves.
9. Derive Long run cost curve.
10. Write a note on Envelop curve.

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UNIT -IV
UNIT -4
MARKET STRUCTURE ANALYSIS -I
Unit Structure:
4.0 Objectives
4.1 Introduction
4.2 Difference between Perfect Competition and Imperfect
Competition
4.3 Sources of Monopoly Power
4.4 Monopoly -Price Discrimination
4.5 What is1stDegre e(Perfect) Price Discrimination?
4.6 Equilibrium Conditions ofADiscriminating Monopoly
4.7 Output under Price Discrimination
4.8 Meaning ofMonopoly Power
4.9 Summary
4.10 Questions
4.0 OBJECTIVES
To familiar students with Concept of perfectly and im perfectly
competitive markets
To acquaint the students with difference between Perfect competition
and Monopoly
To study the Sources of market power
To study Profit maximization of simple and discriminating monopolist
To understand the Methods of measuri ng monopoly power
To Study Public policy towards monopoly
4.1INTRODUCTION
In the competition between economic models, the theory of
perfect competition holds a dominant market share: economists so
widely and successfully use no set of ideas as is the lo gic of perfectly
competitive markets. Correspondingly, all other market models
(collectively labelled ‘imperfectly competitive’ and including monopoly,
monopolistic competition, dominant -firm price leadership, bilateral
monopoly and other situations of bar gaining, and all the varieties of
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4.2DIFFERENCE BETWEEN PERFECT COMPETITION
AND IMPERFECT COMPETITION
Based on competition, the market structure has been classified into
two broad categories lik e Perfectly competitive and Imperfectly
competitive. Perfect Competition is not found in the real world market
because it is based on many assumptions. But an Imperfect
Competition is associated with a practical approach.
The type of market structure dec ides the market share of a firm in
the market. If there exists a single firm, it will serve the entire market, and
thedemand of the customers are satisfied with that firm only. But if we
increase the number of firms to two, the market will also be shared by the
two. Similarly, if there are about 100 small firms in the market, the market
is shared by all of them in proportion.
Therefore, it is the market structure, which affects the market. So
here we are going to describe the differences between perfect c ompetition
and imperfect competition, in economics.
Content: Perfect Competition Vs Imperfect CompetitionBASIS FOR
COMPARISONPERFECT
COMPETITIONIMPERFECT
COMPETITIONMeaningPerfect Competition is a
type of competitive market
where there are numerous
sellers selling homogeneous
products or services to
numerous buyers.Imperfect Competition is
an economic structure,
which does not fulfill the
conditions of the perfect
competition.Nature of conceptTheoreticalPracticalProduct
DifferentiationNoneSlight to SubstantialPlayersManyFew to manyRestricted entryNoYesFirms arePrice TakersPrice Makers
4.2.1Definition of Perfect Competition
Perfect Competition is an economic structure where the degree of
competition between the firm is at its pe ak. Given are the salient features
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Many buyers and sellers.
Product offered is identical in all respects.
Any firm can come and go, as per its own discretion.
Both the parties to the transaction are having complete knowledge
about the product, quantity, price, market and market conditions as
well.
Transportation and Advertising cost is nil.
Free from government interference.
The price for a product is uniform across the market. It decided by the
demand and supply forces; no firm can affect the prices, that’s why the
firms are price takers.
Each firm earns a normal profit.
Example : Suppose you go to a vegetable market to buy tomatoes. There
are many tomato vendors and buyers. You go to a vendor and inquire
about the cost of 1 kg tomatoes, the vendor replies, it will cost Rs. 10.
Then you go ahead and inquire some more vendors. The prices of all the
vendors are same for the demanded quantity. This is an example of perfect
competition.
Key Differences Between Perfect Competition and Imperfect
Competition
The main points of difference between perfect competition and
imperfect competition in economics are depicted below:
1.The competitive market, in which there are a large number of buyers
and sellers, and the sellers supply identical p roducts to the buyers; it is
known as perfect competition. Imperfect competition occurs when one
or more conditions of the perfect competition are not met.
2.Perfect competition is a hypothetical situation, which does not apply in
the real world. Conversely, Imperfect Competition is a situation that is
found in the present day world.
3.When it comes to perfect competition, there are many players in the
market, but in imperfect competition, there can be few to many
players, depending upon the type of market stru cture.
4.In perfect competition, the sellers produce or supply identical
products. As against, in imperfect competition the products offered by
the sellers can either be homogeneous or differentiated.
5.If we talk about perfect competition, there are no barrie rs to the entry
and exit of the firms which is just opposite in the case of imperfect
competition.
6.In perfect competition, it is assumed that the firms do not influence the
price of a product. Hence they are price takers but in imperfect
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4.2.2 Conclusion
Perfect competition is an imaginary situation which does not exist
in reality, but imperfect competition is factual i.e. which genuinely exist.
Whichever market, you consider for this like for example if you
consi der the detergent market. There are many players like Tide, Rin, Surf
Excel, Ariel, Ghadi, etc. producing similar product i.e. detergent.
At first instance, you may think that this is an example of perfect
competition, but this is not so. If you dig al i ttle deeper, you may find that
all the products are different as well as they vary in their prices. Some are
low budget detergents for capturing the market of price sensitive people
while others are high budget detergents for quality sensitive people.
Am o nopoly, on the other hand, exists when there is only one
producer and many consumers. Monopolies are characterized by a lack of
economic competition to produce the good or service and a lack of viable
substitute goods. As a result, the single producer has control over the price
of a good –in other words, the producer is a price maker that can
determine the price level by deciding what quantity of a good to produce.
Public utility companies tend to be monopolies. In the case of electricity
distribution, for example, the cost to put up power lines is so high it is
inefficient to have more than one provider. There are no good substitutes
for electricity delivery so consumers have few options. If the electricity
distributor decided to raise their prices it is l ikely that most consumers
would continue to purchase electricity, so the seller is a price maker.Table 4.1Characteristics of Perfect Competition and MonopolyCharacteristicPerfect CompetitionMonopolyMarketLarge number ofsellers and buyersproducing ahomogeneous good orservice, easy entry.Large number of buyers, oneseller. Entry is blocked.Demand andmarginal
revenue curvesThe firm’s demand andmarginal revenuecurve is a horizontalline at the marketprice.The firm faces the marketdemandcurve; marginalrevenue is below marketdemand.PriceDetermined by demandand supply;Each firmis a price taker.
Priceequals marginalcost.The monopoly firm determinesprice; it is a price setter. Price isgreater than marginal cost.munotes.in

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179Table 4.1Characteristics of Perfect Competition and MonopolyCharacteristicPerfect CompetitionMonopolyProfit
maximiza tionFirms produce wheremarginal cost equalsmarginal revenueFirms produce where marginalcost equals marginal revenueand charge the correspondingprice on the demand curve.ProfitEntry forces economicprofit to zero in thelong run.Because entry isblocked, amonopoly firm can sustain aneconomic profit in the long run.EfficiencyThe equilibriumsolution is efficientbecause price equalsmarginal cost.The equilibrium solution isinefficient because price isgreater than marginal cost.
4.3SOURCE S OF MONOPOLY POWER
Why are some markets dominated by single firms? What are the
sources of monopoly power? Economists have identified a number of
conditions that, individually or in combination, can lead to domination of
a market by a single firm and cre ate barriers that prevent the entry of new
firms.
Barriers to entry are characteristics of a particular market that
block new firms from entering it. They include economies of scale, special
advantages of location, high sunk costs, a dominant position in the
ownership of some of the inputs required to produce the good, and
government restrictions. These barriers may be interrelated, making entry
that much more formidable. Although these barriers might allow one firm
to gain and hold monopoly control over a market, there are often forces at
work that can erode this control.
4.3.1Economies of Scale
Scale economies and diseconomies define the shape of a firm’s
long-run average cost ( LRAC ) curve as it increases its output. If long -run
average cost declines as the level of production increases, a firm is said to
experience economies of scale .
A firm that confronts economies of scale over the entire range of
outputs demanded in its industry is a natural monopoly . Utilities that
distribute electricity, water, an d natural gas to some markets are examples.
In a natural monopoly, the LRAC of any one firm intersects the market
demand curve where long -run average costs are falling or are at a
minimum. If this is the case, one firm in the industry will expand to
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lower unit costs than its rivals, it can drive them out of the market and gain
monopoly control over the industry.
Suppose there are 12 firms, each operating at the scale shown
byATC 1(average total cost) in Figure 10.1 “Economies of Scale Lead to
Natural Monopoly”. A firm that expanded its scale of operation to achieve
an average total cost curve such as ATC 2could produce 240 units of
output at a lower cost than could the smaller firm s producing 20 units
each. By cutting its price below the minimum average total cost of the
smaller plants, the larger firm could drive the smaller ones out of business.
In this situation, the industry demand is not large enough to support more
than one fi rm. If another firm attempted to enter the industry, the natural
monopolist would always be able to undersell it.
Figure 4.1Economies of Scale Lead to Natural Monopoly
A firm with falling LRAC throughout the range of outputs relevant
to existing deman d(D) will monopolize the industry. Here, one firm
operating with a large plant ( ATC 2) produces 240 units of output at a lower
cost than the $7 cost per unit of the 12 firms operating at a smaller scale
(ATC 1), and producing 20 units of output each.
4.3.2Location
Sometimes monopoly power is the result of location. For example,
sellers in markets isolated by distance from their nearest rivals have a
degree of monopoly power. The local movie theater in a small town has a
monopoly in showing first -run movies . Doctors, dentists, and mechanics
in isolated towns may also be monopolists.
4.3.3 Sunk Costs
The greater the cost of establishing a new business in an industry,
the more difficult it is to enter that industry. That cost will, in turn, be
greater if the outlays required to start a business are unlikely to be
recovered if the business should fail.Suppose, for example, that entry into
a particular industry requires extensive advertising to make consumers
aware of the new brand. Should the effort fail, there is no way to recover
the expenditures for such advertising. An expenditure that has already
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If a substantial fraction of a firm’s initial outlays will be lost upon
exit from the industry, exit will be costly. Difficulty of exit can make for
difficulty of entry. The more firms have to lose from an unsuccessful
effort to penetrate a particular market, the less likely they are to try. The
potential for high sunk costs could thus contribute to the monopoly power
of an established firm by making entry by other firms more difficult.
4.3.4Restricted Ownership of Raw Materials and Inputs
In very few cases the source of monopoly power is the ownership
of strategic inputs. If a particular firm owns all of an input required for the
production of a particular good or service, then it could emerge as the only
producer of that good or service.
The Aluminum Company of America (ALCOA) gained monopoly
power through its ownership of virtually all the bauxite mi nes in the world
(bauxite is the source of aluminum). The International Nickel Company of
Canada at one time owned virtually all the world’s nickel. De Beers
acquired rights to nearly all the world’s diamond production, giving it
enormous power in the mark et for diamonds. With new diamond supplies
in Canada, Australia, and Russia being developed and sold independently
of DeBeers, however, this power has declined, and today DeBeers controls
a substantially smaller percentage of the world’s supply.
4.3.5 Gov ernment Restrictions
Another important basis for monopoly power consists of special
privileges granted to some business firms by government agencies. State
and local governments have commonly assigned exclusive franchises —
rights to conduct business in a sp ecific market —to taxi and bus
companies, to cable television companies, and to providers of telephone
services, electricity, natural gas, and water, although the trend in recent
years has been to encourage competition for many of these services.
Government s might also regulate entry into an industry or a profession
through licensing and certification requirements. Governments also
provide patent protection to inventors of new products or production
methods in order to encourage innovation; these patents may afford their
holders a degree of monopoly power during the 17 -year life of the patent.
Patents can take on extra importance when network effects are
present. Network effects arise in situations where products become more
useful the larger the number of us ers of the product. For example, one
advantage of using the Windows computer operating system is that so
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Figure 4.2
Monopoly : In a monopoly market, the margin al revenue curve and the
demand curve are distinct and downward -sloping. Production occurs
where marginal cost and marginal revenue intersect.
Figure 4.3
Perfect Competition :In a perfectly competitive market, the marginal
revenue curve is horizontal a nd equal to demand, or price. Production
occurs where marginal cost and marginal revenue intersect.
4.4MONOPOLY -PRICE DISCRIMINATION
What isprice discrimination?
Price discrimination happens when a firm charges a different price
to different groups o f consumers for an identical good or service, for
reasons not associated with costs of supply.
4.4.1Themain aims ofprice discrimination
0. Extra Revenue
0. Higher Profit
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4.4.2The difference between price discriminat ion and product
differentiation
Charging different prices for similar goods is not pure price
discrimination
Product differentiation gives a supplier greater control over price and
the potential to charge consumers a premium price arising from
differences in the quality or performance of a product
4.4.4The main conditions necessary forprice discrimination to
work?
Here are the main conditions required for discriminatory pricing:
Differences inprice elasticity ofdemand: There must be a different
price e lasticity of demand for each group of consumers. The firm is then
able to charge a higher price to the group with a more price inelastic
demand and a lower price to the group with a more elastic demand. By
adopting such a strategy, the firm can increase total
revenue andprofits (i.e. achieve a higher level of producer surplus). To
profit maximize, the firm will seek to set marginal revenue = to marginal
cost in each separate (segmented) market.
Barriers toprevent consumers switching from one supplier to
another: The firm must be able to prevent "consumer switching" –i.e.
consumers who have purchased a product at a lower price are able to re -
sell it to those consumers who would have otherwise paid the expensive
price.
This can be done in a number of ways, –and is probably easier to
achieve with the provision of a unique service such as a haircut, dental
treatment or a consultation with a doctor rather than with the exchange of
tangible goods such as a meal in a restaurant.
Switching might be prevented by selling a product to consumers at
unique moments intime –for example with the use of airline tickets
for a specific flight that cannot be resold under any circumstances or
cheaper rail tickets that are valid for a specific rail service.
Software busines ses often offer heavy price discounts for educational
users providing they give an academic email address
Students may be required to show proof of identification using secure
ID cards
Price discrimination is easier when there are separate anddistinct
markets for a firm's products and when price elasticity ofdemand
varies from one group of consumers to another .
Summary of the main conditions
Two main conditions required for price discrimination to work
1.Differences in Price Elasticity of Demand
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b)Charge lower price to consumers with a more Price elasticity of
demand
0.Prevent Resale / Consumer Switching
b)Easier with services than goods
b)Time Limits -product brought at certain time
b)Photo cards / identification systems
b)Electronic / Digital ways of protecting usage.
4.5WHAT IS1ST DEGREE (PERFECT) PRICE
DISCRIMINATION?
Perfect Price Discrimination ischarging whatever themarket willbear
Sometimes known as optimal pricing , with perfect price
discrimination, the firm separates the market into each individual
consumer and charges them the price they are willing and able to pay
If successful, the firm can extract theentire consumer surplus that
lies underneath the demand curve and turn it into extrarevenue or
producer surplus .
This is hard to achieve unless a business has full information on
every consumer's individual preferences and willingness to
pay. Thetransactions costs involved in finding out through market
research what each buyer is pre pared to pay is the main barrier to a
business's engaging in this form of price discrimination.
If the monopolist can perfectly segment themarket , then the average
revenue curve becomes the marginal revenue curve.
A monopolist will continue to sell extra units as long as the extra
revenue exceeds the marginal cost of production.
In reality, most suppliers and consumers prefer to work with price
listsandmenus from which trade can take place rather than having to
negotiate a price for each unit bought and old. Pure price
discrimination
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4.5.1What isSecond Degree Price Discrimination?
This involves businesses selling off packages orblocks ofa
product deemed to be surplus capacity at lower prices than the
previously published or advertised p rice.
Price tends to fall as the quantity bought increases.
Examples of this can be found in the hotel industry where spare
rooms are sold on a last minute standby basis . In these types of
industry, the fixed costs of production are high. At the same time
themarginal orvariable costs are low and predictable.
If there are unsold rooms, it is in the hotel's best interest to offload
spare capacity at adiscount prices , providing that the extra revenue
at least covers the marginal cost of each unit.
There is nearly always some supplementary profit to be made. Firms
may be quite happy to accept a smaller profit margin if it means that
they manage to steal an advantage on their rival firms.
Second Degree Price Discrimination
0.Selling blocks of tickets/ products in larger quantities.
0.Getting rid of excess inventories / stocks when demand is low,
0.Standby tickets for hotels, theatres, flights etc.
0.Peak & Off -peak pricing schemes e.g. travel, Telecommunications
4.5.2Early -bird discounts –generating extra cash flowfora
business
Customers booking early with airline carriers such as EasyJet or
RyanAir will normally find lower prices if they are prepared to book early.
This gives the airline the advantage of knowing how full their flights are
likely to be and is a source ofcash flow prior to the flight taking off.
Closer to the time of the scheduled service the price rises, on the
justification that consumer's demand for a flight becomes inelastic. People
who book late often regard travel to their intended destinat ion as a
necessity and they are likely to be willing and able to pay a much higher
price.
4.5.3Peak andOff-Peak Pricing
Peak and off -peak pricing and is common in the telecommunications
industry, leisure retailing and in the travel sector.
For example, telephone and electricity companies separate markets by
time:
There are three rates for telephone calls: a daytime peak rate, and an
off peak evening rate and a cheaper weekend rate.
Electricity suppliers also offer cheaper off -peak electricity during the
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Atoff-peak times , there is plenty ofspare capacity and marginal
costs of production are low (the supply curve is elastic)
Atpeak times when demand is high, short run supply becomes
relatively inelastic as the supplier reaches capacity constraint s.A
combination of higher demand and rising costs forces up the profit
maximizing price.
4.6EQUILIBRIUM CONDITIONS OFA
DISCRIMINATING MONOPOLY
A discriminating monopolist, like an ordinary monopolist, tries to
get maximum profits. He would supply the product in different amounts to
achieve his ultimate goal. In fact, his action of price discrimination is
profitable if the elasticity of demand in one market is different from the
elasticity of demand in the other.
If the elasticity of demand for the pro duct of the monopolist is
greater in market A than what it is in market B, the monopolist would gain
by reducing the supply in market B and thereby increasing the supply in
market A. If a discriminating monopolist is to be in equilibrium, two
separate cond itions have to be fulfilled.
(1)Marginal revenue inboth (orall)markets must bethesame:
When the elasticity of demand for a monopolist’s product is
different in different markets, he would supply a smaller amount and
charge a high price for the produ ct where the demand is inelastic; but he
would supply a larger amount and charge a low price for the same where
the demand is elastic. By doing so, he will have to equalize the marginal
revenue in both or all markets.
(2)The marginal revenue derived from each ofthese markets must
alsoequal themarginal costofthemonopolist’s total output:
It means that the monopolist would supply the different amounts in
A and B markets in such a way and up to that amount at which the
marginal revenue from the sale in each of these markets must be equal to
the monopolist’s marginal cost of producing the total output (aggregate of
output in A and B).
Inother words, theequilibrium condition ofadiscriminating
monopolist becomes:
MR 1(marginal revenue in market A) = M R2(marginal revenue in market
B) = MC.
These two conditions are nothing more than an application of the
general principle of equilibrium, i.e., MR = MC.
The equilibrium under discriminating monopoly can be shown in
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revenue curves of the firm for two separate markets (sub -market A and
sub-market B). These markets have different elasticities of demand at each
price. In Fig. 4.5(c) the profit maximizing output (OM) is shown at the
intersection of the marginal cost curve (MC) for the monopolist’s whole
output, with the curve showing combined marginal revenue (CMR)
obtained from the two markets. The curve CMR is obtained by adding the
curves MR 1and MR 2together sideways.
Figure 4.5 : Equilibrium of a Discriminating Monopolist
In this equilibrium situation, the output is OM, and marginal
revenue is OL or MR. The output OM has, therefore, to be distributed
between the two separate markets in such a way that marginal revenue in
each is OL. It means that OM’ is to be sold in sub -market A at price OP
(marginal revenue is here OL).
Similarly, OM” must be sold in sub -market B at a price of OP”
(marginal revenue here is also OL). The monopolist’s profit is shown by
the area ARB in Fig. 10(c) and here it is at a maximum.
4.7OUTPUT UNDER PRICE DISCRIMINATION
The total output of a monopolist with two or more prices can be
either larger or smaller than his total output if he would sell at one price.
Conceiv ably, too, a monopolist could have an output equal to the output
corre sponding to conditions of pure competition.
In practice, demand and cost relations can be such that without
discrimi natio n a particular commodity or service will not be produced at
all. Take the case of India’s sugar industry. If free sale of sugar is
prohibited produc tion of sugar will be unprofitable.
Some commodities and services might not be produced at all if
sellers were not be able or were not allowed to practice price
discrimination. The standard and simple example is the physician in a
small village. Similarly, railroad service on a particular route might
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4.7.1Preconditions ofPrice Discrimination:
It is obvious that discrimination between buyers is not possible
under perfect competition because of the existence of a large number of
sellers selling an identical product. It can only occur when there is a
monopoly. But even under monopoly it is not always possible. A.C. Pigou
has mentioned two important conditions for the successful operations of
price discrimina tion by a monopolist.
1.NoPossibility ofResale ofProduct:
A monopolist succeeds in price -discrimination where the
products, mainly the services, cannot be resold or when the resale of the
product or leakage of the product from low -priced to high -priced market
can be prevented. A doctor having a monop oly position in a particular
locality can charge rich patients high fee but poor patients low fee, for his
services rendered.
Here, he becomes successful because his services cannot be resold.
Similarly, lawyers and business consultants some times charge rates for
their services that vary according to the incomes of their clients. Direct
personal services like teaching, legal advice, haircut, modelling, etc.,
which cannot be resold by the buyers, foster price discrimi nation.
Acommodity cannot beresold when itfulfills twoimportant con-
ditions:
(a) Units of its demand cannot be transferred from high -priced to low -
priced markets, and(b) Units of its supply cannot be transferred from low -
priced to high -priced markets.
In other words, arbitrage (transfer of the commodity from low -
priced to high -priced market) can be stopped somehow.
2.Separation ofMarkets:
Price discrimination is also possible when markets are separated
from one another. Geographically or politically markets cannot meet one
another for t he re -buying or the re -selling of the products. Dumping is an
outstanding example of this type of discriminating monopoly.
4.8BESIDES THESE TWO CONDITIONS, PRICE
DISCRIMINATION ISALSO POSSIBLE UNDER THE
FOLLOWING CONDITIONS
(a) A monopolist becomes suc cessful in price discrimination on account of
consumers’ peculiarities; such as consumers’ ignorance about the prices,
consumers’ irrational feeling about the quality of the product, consumers’
indifference towards small price differences, etc.
(b) Again, a monopolist becomes successful in price discrimination when
the demand for his product has different elasticities in two sub -markets or
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where its demand is inelastic (e.g., woolen dr esses at cold places) but at
low prices in the other sub -markets where its demand is elastic (e.g.,
woolen dresses at warm places).
It will pay the monopolist to transfer units of output from one
market to other markets when the elasticity in two markets is different. In
fact, the price discrimination will be profitable only when elasticity of
demand in one market (or sub -market) is different from that in the other.
(c) When there is no state intervention or legal bar, a monopolist can
successfully practi se price discrimination.
(d) Finally, price discrimination is also possible when buyers and sellers
are separated from one another by a great distance.
These conditions can also be extended to cover the case where a
firm is a monopolist in one market but is operating under conditions of
perfect competition in another. In this case, the marginal cost of producing
the whole output must equal the price prevailing in the perfect market.
The part of the output, which is sold in the monopolised market,
must be so restricted as to equalise the marginal revenue in that market to
the marginal cost of the whole output. The price in the latter market will
be higher than the price prevailing in the perfect market. This consequence
follows from the fact that in the pe rfect market the average revenue curve
of the firm is a horizontal straight line while in the other market it is
downward sloping.
The relationship between marginal revenue and price is given by
the formula :
MR = p (1 –1/e).
Using thesymbols indicat edearlier wegetthefollowing equations:
Marginal Revenue in market A = p 1{1–1/e1}
Marginal Revenue in market B = p 2{1–1/e2}
It has been shown that when the monopolist is earning maximum
net revenue, the marginal revenues in the two markets must b e equal.
There fore, atequilibrium:
P1{1–1/e1}=p 2{1–1/e2}
In this equation if e 1=e2then p 1=p2. Therefore, it follows that when
the demand -elastics (in the different markets, at the relevant output levels)
are equal, the monopolist will charge t he same price in the different
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elasticities are different, price -discrimination is profitable, and therefore
possible.
The relationship between the price in the two markets (p1: p2) can
be calculated from the equation given above. In general, the price will be
higher in the market where the elasticity of demand is lower.
The analysis of price discrimination, given above, can be easily
extended to the case of more than two markets. Exampl e1:
Suppose that elasticity in market A is equal to 2 and elasticity in market B
is equal to 3. Then,
12
1
21111231143
1312pp
p
p


If in market A, Price is p 1= Rs. 4, then in market B, price is p 2=
Rs. 3.
Example:
Amonopolist hastwomarkets and thedemand schedules in
them areasfollows:
Market A Market B
Price (Rs.) Quantity Price (Rs.) Quantity
50 400 60 600
40 600 50 800
30 900 40 1,100
20 1,000 30 1,400
He wants to sell 1,400 units. What price will he set in the two
markets and why?
Solution:
A discriminating monopolist reaches equilibrium and hence
maximizes profit when he equates the marginal revenue(s) in -both the
markets, i.e., MR 1= MR 2. If this condition holds total revenue will be
maximum and revenue maximization subject to cost c onstraint implies
profit maximization. So, we may calculate total revenue from each market
for different price -quantity combinations and then the corresponding MR.
So, when the firm sells 600 units in market I, at a price of Rs. 40
per unit and 800 units in market 2 at a price of Rs. 50, MR 1= MR 2and
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No other combi nation of Q 1and Q 2will yield the same total revenue and
hence raise profit further.
Market A Market B
P Q TR MR P Q TR MR
Rs. Rs. Rs. Rs. Rs. Rs.
50 400 20,000 60 600 36,000
20 20
40 600 24,000 50 800 40,000
10 13.3
30 900 27,000 40 1,100 44,000
-70 -0.66
20 1,000 20,000 30 1,400 4,200
Check your progress:
1.Distinguish between Per fect competition and Imperfect competition.
2.State the sources of monopoly power.
3.State the conditions under which price discrimination is possible.
4.Explain the meaning of discriminating monopoly.
5.Differentiate between First degree and Secon d degree price
discrimination.
4.8MEANING OFMONOPOLY POWER
The monopolist is the only seller in the market of his product. As
the only seller, he possesses a monopolistic dominance or monopoly
power in the market. But the degree of monopoly power is not the same in
the case of all monopolies. Generally speaking, the less elastic is the
demand for a monopolist’s product, the more would be his degree of
monopoly power, and vice versa.
That is, the degree of monopoly power depends upon the
nume rical coefficient (e) of the price -elasticity of demand for the
monopolist’s product —a higher degree of monopoly power would be
obtained at a smaller value of e and a lower degree of monopoly power at
a larger value of e. This idea is supported by the form ula given by Prof. A.
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According to Prof. Lerner, degree of monopoly power in perfect
competition is zero. At the equilibrium point of a competitive firm, we
have p = AR = MR = MC, or p = MC, o r
p–MC = 0.
On the other hand, at the equilibrium point of a monopolistic firm,
we have
p = AR > MR = MC, or, p > MC, or, p –MC = positive. Prof. Lerner
thinks that the larger the positive value of p –MC as a proportion of p, the
larger would be the degree of monopoly power. Therefore, his formula for
the degree of monopoly power is
4.8.1 Lerner’s Index of monopoly power = p –MC/p
(11.48)
It is obvious from (11.48) that under perfect competition, the value
of this index is zero (p –MC = 0), and in the case of monopoly, this index
would be positive (p > MC).
Wemay now easily obtain therelation between theLerner’s Index
andtheprice -elasticity ofdemand fortheproduct:
https://www.economicsdiscussion.net/wp -content/uploads/2016/09/image -
27.png
That is, the Lerner’s Index of monopoly power is nothing but the
reciprocal of the numerical coefficient of price -elasticity of demand for the
product, which supports our idea that the less elastic is the demand for the
product, the more would be the degree of monopoly power, and vice
versa.
We may easily understand the economic meaning of this idea. The
smaller the price -elasticity of demand, i.e., the value of e, the smaller
would be the response of demand for the product in response to a change
in its price and the larger would be the power of the monopolist to charge
a price in excess of MC, i.e., the larger would be value of p –MC and,
therefore, of the Lerner’s Index.
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4.8.2 Measures ofMonopoly Power under Price Discrimination:
Under price discrimination, the firm is able to discriminate
between different markets in re spect of the price of its product. This is
proof enou gh that the firm possesses some monopoly power.
We have seen that if the monopolist practices price -discrimination
in two markets, then the prices charged in the two markets, p 1and p 2,a r e
known to us. Now, if we know the elasticity of demand in only one of the
markets, we may obtain a measure of monopoly power of the firm. In the
previous case, e 2was known to be equal to ∞.B u t ,i fe 2is not known to us
exactly, then also, we may have an estimate of monopoly power on the
basis of some assumptions about
4.8.3 Concentration Ratios asMeasures ofMonopoly Power:
In an industry, usually there exist some smaller firms and some
larger firms in the sense that smaller firms have relatively smaller shares
in total industry sales (or profits or assets), and the larger firms have
relatively larger shares. That is, sales (or profits or assets) may be more
concentrated in a few firms of the industry, or such concentr ation may be
less. Now, the size of the largest firms’ share in total industry sales, etc. is
known as the concentration ratio.
For example, if we consider sales as the criterion, then the n largest
firms’ share in total industry sales is called an n -firm concentration ratio
which is denoted by CR n. Usually, the four firm and eight firm
concentration ratios denoted by CR 4and CR 8, are used as a measure of
monopoly power.
The concentration ratio may act as a measure of monopoly power
because in a competi tive industry, sales are more evenly distributed
among firms —concentration of sales is more or less absent. On the other
hand, in a monopolistic industry, sales tend to concentrate in a few large
firms —in the limiting case, sales are concentrated in only on e firm when
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Letussuppose thatthere arefivefirms inanindustry, andtheshares
ofthefirms arranged inadescending order areasfollows:
We can compute the cumulative shares for the n largest firms for n
= 1, 2 , 3, 4, 5.
These cumulative shares are:
We have obtained above that the cumulative share of the first two
largest firms (CR 2) is 0.80. Similarly, CR 3= 0.90, CR 4= 0.96 and CR 5=
1.00. If we plot the cumulative percentage of sales against the cumulativ e
number of firms from largest to smallest, we would obtain a curve called
the concentration curve. The concentration curves of three typical
industries have been shown in Fig. 4.6.
The figure shows us that concentration is larger in industry A than
in the industries B and C. But whether concentration is larger in B or C
depends on whether we are comparing the concentrations in the largest
four firms (CR 4) or in the largest eight firms (CR 8).
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If we look at CR 4, concentration is larger in industry B, but if we
look at CR 8, concen tration is larger in industry C. This is the basic defect
of concentration ratios as measures of monopoly power.There may be
another problem also with the concentration ratios. From the point of view
of sales, one industry may be more concentrated than another and, from
the point of view of profits or assets the latter may be more concentrated
than the former.
A third problem with the concentration ratio is that it does n ot take
into account the number of firms. For example, in the example of five
firms we have obtained CR 4= 0.96. In another industry with 100 firms the
CR 4may also be obtained to be 0.96. We cannot really compare the
monopoly power or the competitiveness in these two industries, since the
numbers of firms in the two cases are different.
A fourth problem with the concentration ratios is that they are
usually based on the distribu tion of firms in the domestic industry and they
completely ignore the picture in the foreign sector. Yet the existence of
foreign competition might considerably affect the behaviour of the
domestic firms.
4.8.4TheHerfindahl Index forMeasuring Monopoly Power:
The Herfindahl Index (named after Orris C. Herfindahl) avoids
some of the major problems involving the use of concentration ratios
(CRs).
This index isdenoted byHIanddefined as:21niiHI S(4.1)
where n is the number of firms in the industry and S; is the market share of
the ith firm (i = 1,2, …, n). As is evident, this index reflects both the
number of firms and their relative sizes. For, the example we have already
considered, HI to be obtained would be
HI = (0.50)2+ (0.30)2+ (0.10)2+ (0.06)2+ (0.04)2= 0.35 52.
In case all the firms had equal market shares of 0.2, the
Herfindahl Index would be
HI = 5 (0.2)2= 1/5
That is, if there are n firms in an industry all having equal shares, the share
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(4.2)
Thus, HI depends solely on two things, viz., the variance of the
market shares and the number of firms. If the market share is equally
distributed among the firms, i. e., if σ2= 0, the measure of monopoly
power which is given by the HI, would assume the value 1/n, and this is
also the minimum value of the HI (.
..σ2≥0) for a given n.
Therefore, if there are many firms in the industry that are more or
less of equal s ize, the value of HI would be small, since n is large and σ2is
close to zero. On the other hand, if n = 1, then we would have σ2= 0, and
in that case the HI would be equal to 1.
In other words, in the case of pure mo nopoly, the HI would be
equal to 1, and it is the maximum value of HI. That is, we have obtained
that the HI would lie between and 1, both ends inclusive (1/n ≤HI≤1),
and a larger HI indicates a greater monopoly power.
Public policy toward monopoly generally recognizes two
important dime nsions of the monopoly problem. On the one hand, the
combining of competing firms into a monopoly creates an inefficient and,
to many, inequitable solution. On the other hand, some industries are
characterized as natural monopolies; production by a single firm allows
economies of scale that result in lower costs.
The combining of competing firms into a monopoly firm or
unfairly driving competitors out of business is generally forbidden in the
United States. Regulatory efforts to prevent monopoly fall under the
purview of the nation’s antitrust laws, discussed in more detail in a later
chapter.
At the same time, we must be careful to avoid the mistake of
simply assuming that competition is the alternative to monopoly, that
every monopoly can and should be re placed by a competitive market. One
key source of monopoly power, after all, is economies of scale. In the case
of natural monopoly, the alternative to a single firm is many small, high -
cost producers. We may not like having only one local provider of wate r,
but we might like even less having dozens of providers whose costs —and
prices —are higher. Where monopolies exist because economies of scale
prevail over the entire range of market demand, they may serve a useful
economic role. We might want to regulate their production and pricing
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Where a natural monopoly exists, the price charged by the firm and
other aspects of its behavior may be subject to regulation. Water or natural
gas, for example, a re often distributed by a public utility —a monopoly
firm—at prices regulated by a state or local government agency.
Typically, such agencies seek to force the firm to charge lower prices, and
to make less profit, than it would otherwise seek.
Although ec onomists are hesitant to levy blanket condemnations of
monopoly, they are generally sharply critical of monopoly power where
no rationale for it exists. When firms have substantial monopoly power
only as the result of government policies that block entry, there may be
little defense for their monopoly positions.
Public policy toward monopoly aims generally to strike the
balance implied by economic analysis. Where rationales exist, as in the
case of natural monopoly, monopolies are permitted —and their price sa r e
regulated. In other cases, monopoly is prohibited outright. Societies are
likely to at least consider taking action of some kind against monopolies
unless they appear to offer cost or other technological advantages.
4.9 SUMMARY
1.Based on compet ition, the market structure has been classified into
two broad categories like Perfectly competitive and Imperfectly
competitive. Perfect Competition is not found in the real world market
because it is based on many assumptions. But an Imperfect
Competiti onis associated with a practical approach.
2.Economists have identified a number of conditions that, individually
or in combination, can lead to domination of a market by a single firm
and create barriers that prevent the entry of new firms. Barriers to
entry are characteristics of a particular market that block new firms
from entering it. They include economies of scale, special advantages
of location, high sunk costs, a dominant position in the ownership of
some of the inputs required to produce the go od, and government
restrictions. These barriers may be interrelated, making entry that
much more formidable.
3.Price discrimination happens when a firm charges a different price to
different groups of consumers for an identical good or service, for
reaso ns not associated with costs of supply.
4.Price discrimination is easier when there are separate and distinct
markets for a firm's products and when price elasticity ofdemand
varies from one group of consumers to another .
5.First degree price discrim ination, s ometimes known as optimal
pricing ,with perfect price discrimination, the firm separates the
market into each individual consumer and charges them the price
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6. Second degree price discrimination involves business es selling
offpackages orblocks ofaproduct deemed to be surplus
capacity at lower prices than the previously published or advertised
price.
7.A discriminating monopolist, like an ordinary monopolist, tries to get
maximum profits. He would supply the product in different amounts to
achieve his ultimate goal. In fact, his action of price discrimination is
profitable if the elasticity of demand in one market is different from
the elasticity of demand in the other.
8.The monopolist is the only seller in the market of his product. As the
only seller, he possesses a monopolistic dominance or monopoly
power in the market. But the degree of monopoly power is not the
same in the case of all monopolies. Generally speaking, the less elastic
is the demand for a monopolist’s product, the more would be his
degree of monopoly power, and vice versa.
8.In an industry, usually there exist some smaller firms and some larger
firms in the sense that smaller firms have relatively smaller shares in
total industry sales (or profits or assets), and the larger firms have
relatively larger shares. That is, sales ( or profits or assets) may be
more concentrated in a few firms of the industry, or such concentration
may be less. Now, the size of the largest firms’ share in total industry
sales, etc. is known as the concentration ratio.
4.10 QUESTIONS
1.Explain the various sources of monopoly power.
2.When price discrimination is possible?
3.Discuss First degree price discrimination.
4.Explain the Second degree price discrimination.
5.Write a note on discriminating monopoly.
6.Explain the degree of monopoly power.
7.Write a notes on the following
a) Concentration ratio
b) Marshall Lerner index of measuring of monopoly power
c) Herfindhal index of measuring monopoly power
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UNIT -4A
MARKET STRUCTURE ANALYSIS -II
Unit Structure:
4A.0 Objectives
4A.1 Introduction : Different forms of Imperfect Competition
4A.2 Definition of Imperfect Competition
4A.3 Monopolistic Competition
4A.4 Features ofMonopolistic Competition
4A.5 Demand Curve under Monopolistic Competition
4A.6 Demand Curve: Monopolistic Competition vs.Monopoly
4A.7 Monopolistic Competition inthe Long -Run
4A.8 Wastes o f Monopolistic Competition areinB r i e f as Follows
4A.9 Oligopoly Models
4A.10 Firms behaviour Under Oligopoly
4A.11 Strategic Interactions
4A.12 Cournot Model
4A.13 Dominant Firm Model: Price Leadership
4A.14 Cartels
4A.15 Non-Collusive Oligopoly -Sweezy’s Kinked Demand Curve Model
(Price -Rigidity)
4A.16 Collusive Oligopoly
4A.17 Collusion –Meaning and Examples
4A.18 Game Theory and Collusion
4A.19 The Basics of Game Theory
4A.20 Prisoner’s Dilemma
4A.21 Cournot Competition
4A.22 Centipede Game
4A.23Traveler’s Dilemma
4A.24 Battle ofT h eS e x e s
4A.25 Dictator Game
4A.26 Peace War
4A.27 Volunteer’ sD i l e m m a
4A.28 The Prisoner’s Dilemma in Business and The Economy
4A.29 Evaluating Best Course of Action
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4A.31 Applications to Business
4A.32 Applications to The Economy
4A.33 Summary
4A.34 Questions
4A.0 OBJECTI VES
To familiar students with Concept of Different forms of imperfect
competition
To acquaint the students with Monopolistic competition and Oligopoly
To study the Strategic decision making in oligopoly markets
To understand colliding oligopoly : rivalry among few, price war and
kinked demand curve
To study basic concepts of game theory
To understand Using Game theory to analyse strategic decisions
To familiar with the application of model of prisoner’s dilemma in
market decisions
4A.1 INTRODUCTION: DI FFERENT FORMS OF
IMPERFECT COMPETITION
An imperfect market refers to any economic market that does not
meet the rigorous standards of the hypothetical perfectly —or purely —
competitive market. Pure or perfect competition is an abstract, theoretical
market s tructure in which a series of criteria are met. Since all real markets
exist outside of the spectrum of the perfect competition model, all real
markets can be classified as imperfect markets.
In an imperfect market, individual buyers and sellers can influ ence
prices and production, there is no full disclosure of information about
products and prices, and there are high barriers to entry or exit in the
market.
Perfect competition, market equilibrium, and an unlimited number
of buyers and sellers characteri ze a perfect market.
4A.2 DEFINITION OF IMPERFECT COMPETITION
The competition, which does not satisfy one or the other condition,
attached to the perfect competition is imperfect competition. Under this
type of competition, the firms can easily influenc e the price of a product in
the market and reap surplus profits.
In the real world, it is hard to find perfect competition in any
industry, but there are so many industries like telecommunications,
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where you can find imperfect competition . By the virtue of this,
imperfect competition is also considered as real world competition.
There are various forms of imperfect competition, described below:
Monopoly : Single seller dominates the ent ire market.
Duopoly : Two sellers share the whole market.
Oligopoly : Few sellers are there who either act in collusion or
competition.
Monopsony : Many sellers and a single buyer.
Oligopsony : Many sellers and few buyers.
Monopolistic Competition : Numerous se llers offering unique
products.
Imperfect markets do not meet the rigorous standards of a hypothetical
perfectly or purely competitive market.
Imperfect markets are characterized by having competition for market
share, high barriers to entry and exit, diff erent products and services,
and a small number of buyers and sellers.
Perfect markets are theoretical and cannot exist in the real world; all
real-world markets are imperfect markets.
Market structures that are categorized as imperfect include
monopolies, oligopolies, monopolistic competition, monopsonies, and
oligopsonies.
4A.2.1Types of Imperfect Markets
When at least one condition of a perfect market is not met, it can
lead to an imperfect market. Every industry has some form of
imperfection. Imperfe ct competition can be found in the following
structures:
4A.2.2Monopoly
This is a structure in which there is only one (dominant) seller.
Products offered by this entity have no substitutes. These markets have
high barriers to entry and a single seller w ho sets the prices on goods and
services. Prices can change without notice to consumers.
4A.2.3Oligopoly
This structure has many buyers but few sellers. These few players
in the market may bar others from entering. They may set prices together
or, in the case of a cartel, only one takes the lead to determine the price for
goods and services while the others follow.
4A.2.4Monopolistic Competition
In monopolistic competition, there are many sellers who offer
similar products that can't be substituted. Bus inesses compete with one
another and are price makers, but their individual decisions do not affect
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4A.2.5Monopsony and Oligopsony
These structures have many sellers, but few buyers. In both cases,
the buyer is the one who manipulates market p rices by playing firms
against one another.
4A.3 MONOPOLISTIC COMPETITION
Monopolistic competition is a market structure defined by free
entry and exit, like competition, and differentiated products, like
monopoly. Differentiated products provide each firm with some market
power. Advertising and marketing of each individual product provide
uniqueness that causes the demand curve of each good to be downward
sloping. Free entry indicates that each firm competes with other firms and
profits are equal to ze ro on long run equilibrium. If a monopolistically
competitive firm is earning positive economic profits, entry will occur
until economic profits are equal to zero.
After examining the two extreme market structures, let us now
focus our attention to the market structure, which shares features of both
perfect competition and monopoly, i.e. “Monopolistic Competition”.
Monopolistic Competition refers to a market situation in which there are
large numbers of firms which sell closely related but differentiate d
products. Markets of products like soap, toothpaste AC, etc. are examples
of monopolistic competition.
Monopoly +Competition =Monopolistic Competition
Under monopolistic competition, each firm is the sole producer of
a particular brand or “product”.
i. It enjoys ‘monopoly position’ as far as a particular brand is concerned.
ii. However, since the various brands are close substitutes, its monopoly
position is influenced due to stiff ‘competition’ from other firms.
So, monopolistic competition is a ma rket structure, where there is
competition among a large number of monopolists.
4A.4 FEATU RES OFMONOPOLISTIC COMPETITION
1.Large Number ofSellers:
There are large numbers of firms selling closely related, but not
homogeneous products. Each firm acts i ndependently and has a limited
share of the market. So, an individual firm has limited control over the
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2.Product Differentiation:
Each firm is in a position to exercise some degree of monopoly (in
spite of large number of sellers) through product differentiation. Product
differentiation refers to differentiating the products on the basis of brand,
size, colour, shape, etc. The product of a firm is close, but not perfect
substitute of other firm.
Implication of ‘Product differentiation’ is that buyers of a product
differentiate between the same products produced by different firms.
Therefore, they are also willing to pay different prices for the same
product produced by different firm s. This gives some monopoly power to
an individual firm to influence market price of its product.
Explore More about Product Differentiation:
1.The product of each individual firm is identified and distinguished
from the products of other firms due to p roduct differentiation.
2.To differentiate the products, firms sell their products with different
brand names, like Lux, Dove, Lifebuoy, etc.
3.The differentiation among different competing products may be based
on either ‘real’ or ‘imaginary’ differen ces.
(i)Real Differences may be due to differences in shape, flavour, colour,
packing, after sale service, warranty period, etc.
(ii)Imaginary Differences mean differences which are not really obvious
but buyers are made to believe that such difference s exist through
selling costs (advertising).
4.Product differentiation creates a monopoly position for a firm.
5.Higher degree of product differentiation (i.e. better brand image)
makes demand for the product less elastic and enables the firm to
charge a price higher than its competitor’s products. For example,
Pepsodent is costlier than Babool.
6. Some more examples of Product Differentiation:
(i) Toothpaste: Pepsodent, Colgate, Neem, Babool, etc.
(ii) Cycles: Atlas, Hero, Avon, etc.
(iii) Tea: Brooke Bond, Tata tea, Today tea, etc.
(iv) Soaps: Lux, Hamam, Lifebuoy, Pears, etc.
3.Selling costs:
Under monopolistic competition, products are differentiated and
these differences are made known to the buyers through selling costs.
Selling costs refer to t he expenses incurred on marketing, sales promotion
and adver tisement of the product. Such costs are incurred to persuade the
buyers to buy a particular brand of the product in preference to
competitor’s brand. Due to this reason, selling costs constitute a
substantial part of the total cost under monopolistic competition.
It must be noted that there are no selling costs in perfect
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Similarly, under monopoly, selling costs are of small amou nt (only for
informative purpose) as the firm does not face competition from any other
firm.
4.Freedom ofEntry andExit:
Under monopolistic competition, firms are free to enter into or exit
from the industry at any time they wish. It ensures that there are neither
abnormal profits nor any abnormal losses to a firm in the long run.
However, it must be noted that entry under monopolistic competition is
not as easy and free as under perfect competition.
5.Lack ofPerfect Knowledge:
Buyers and sellers do n ot have perfect knowledge about the market
conditions. Selling costs create artificial superiority in the minds of the
consumers and it becomes very difficult for a consumer to evaluate
different products available in the market. As a result, a particular product
(although highly priced) is preferred by the consumers even if other less
priced products are of same quality.
6.Pricing Decision:
A firm under monopolistic competition is neither a price -taker nor
a price -maker. However, by producing a unique p roduct or establishing a
particular reputation, each firm has partial control over the price. The
extent of power to control price depends upon how strongly the buyers are
attached to his brand.
7.Non-Price Competition:
In addition to price competition, non-price competition also exists
under monopolistic competition. Non -Price Competition refers to
competing with other firms by offering free gifts, making favourable
credit terms, etc., without changing prices of their own products.
Firms under monopolist ic competition compete in a number of
ways to attract customers. They use both Price Competition (competing
with other firms by reducing price of the product) and Non -Price
Competition to promote their sales.
4A.5 DEMAND CURVE UNDER MONOPOLISTIC
COMPETITI ON
Under monopolistic competition, large number of firms selling
closely related but differentiated products makes the demand curve
downward sloping. It implies that a firm can sell more output only by
reducing the price of its product.
As seen in Fig. 4A.1, output is measured along the X -axis and
price and revenue along the Y -axis. At OP price, a seller can sell OQ
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curve under monopolistic competition is negatively sloped as more
quantity can be sold only at a lower price.
Figure 4A.1
MRLike monopoly, MR is also less than AR under monopolistic
competition due to negatively sloped demand curve.
4A.6 DEMAND CURVE: MONOPO LISTIC
COMPETITION VS.MONOPOLY
At first glance, the demand curve of mon opolistic competition
(Fig. 4A.2 ) looks exactly like the dema nd curve under monopoly (Fig.
4A.3) as both faces downward sloping demand curves. However, demand
curve under monopolistic competition is more el astic as compared to
demand curve under monopoly. This happens because differentiated
products under monopolistic competition have close substitutes, whereas
there are no close substitutes in case of monopoly.Let us prove this with
the help of Fi g. 4A .5 (Proof is given just for reference).
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We know, price elasticity of demand (by geometric method) at a
point on the demand curve is given by: E d=L o wer segment of demand
curve / Upper segment of demand curve.
At price ‘OP’, price elasticity of demand under monopolistic
competition is BC/AB and under monopoly is EF/DE. Fig. 10.5 reveals
that BC > EF and DE > AB. So, BC/AB > EF/DE.It means, demand curv e
in case of monopolistic competition is more elastic as compared to
demand curve under monopoly.
4A.7 MONOPOLISTIC COMPETITION IN THE LONG -
RUN
The difference between the short -run and the long -run in a
monopolistically competitive market is that in the long -run new firms can
enter the market, which is especially likely if firms are earning positive
economic profits in the short -run. New firms will be attracted to these
profit o pportunities and will choose to enter the market in the long -run. In
contrast to a monopolistic market, no barriers to entry exist in a
monopolistically competitive market; hence, it is quite easy for new firms
to enter the market in the long -run.
In the short run, a monopolistically competitive firm maximizes
profit or minimizes losses by producing that quantity where marginal
revenue = marginal cost .I faverage total cost is below the market price,
then the firm will earn an economic profit.
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Figure 4A.3
D = Market Demand
ATC = Average Total Cost
MR = Marginal Revenue
MC = Marginal Cost
As can be seen in this graph, the market price charged by the
monopolistic competitive firm = the point on the demand
curve where MR=MC.
4A.7.1Short -Run Profit =(Price -ATC )×Quantity
However, if the average total cost exceeds the market price, then
the firm will suffer losses, equal to the average total cost minus the market
price multiplied by the quantity produced. Losses will still be minimized
by producing that quantity where marginal revenue = marginal cost, but
eventually the firm either must reverse the losses or be forced to exit the
industry.
Short -Run Loss =(ATC -Price )×Quantity
4A.7.2Long -Run Equilibrium: Normal Profits
If the competitive firm s in an industry earn an economic profit,
then other firms will enter the same industry, which will reduce the profits
of the other firms. More firms will continue to enter the industry until the
firms are earning only a normal profit .
However, if there are too many firms, then firms will incur losses,
especially the inefficient ones, which will cause them to leave the
industry. Consequently, the remaining firms will return to normal
profi tability. Hence, the long -run equilibrium for monopolistic
competition will equate the market price to the average total cost, where
marginal revenue = marginal cost, as shown in the diagram below.
Remember, in economics, average total cost includes a norm alprofit.munotes.in

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Figure 4A. 4
Note that where MCrises above MR, the costs exceed additional
revenue, which is why the firm maximizes its profit by producing only
that quantity where MR=MC, and charging the price at position 1in the
graph.
2Market Price = Marginal Cost = Allocative Efficiency
3Productive Efficiency = Minimum ATC
Excess Capacity = Quantity Produced at Minimum ATC –Quantity
yielding the greatest profit ( MR=MC).
Because monopolistically competitive firms do not operate at their
minimum average total cost, they, therefore, operate with excess capacity .
Note in the above diagram that firms would lose money if they produced
more to achieve either allocative or productive efficiency. That most firms
operate with excess capacity is evident wh en looking at most
monopolistically competitive firms, such as restaurants and other retailers,
where salespeople are often idle.
Some firms may have enough of an advantage to continue earning
economic profits, even in the long run. For instance, a busine ss can have
an excellent location relative to other locations in the area, which will
always give it an advantage over other firms in that local market. Or a firm
may have a patent or trademark on its product that prevents competition.
In such cases, firms have some degree of market power that would allow
them to price their products above competitors' prices without losing too
much business.
4A.7.3Productive and Allocative Efficiency of Monopolistic
Competition
Productive efficiency requires that:
Price = Minimum Average Total Cost
Pure competition can achieve productive efficiency, but most
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than the minimum average total cost, and would actually lose money
selling at their minimum ATC. To use their excess capacity, they would
have to produce a quantity equal to their minimum ATC, but they would
not be able to sell that amount without lowering their prices, thus either
reducing their profits or incurring losses.
The monopolistic fi rm also does not achieve allocative
efficiency. Allocative efficiency requires that:
Price = Marginal Cost
The monopolistic firm exhibits a downward sloping demand curve.
That means that, to sell more units, it must lower its price, but if it lowers
its price, then it must lower its price on all units. Thus, like a monopoly,
marginal revenue continually declines as quantity is increased. The firm
maximizes profits when marginal revenue = marginal cost, but this only
occurs at a quantity less than what a pu rely competitive firm would
produce, where marginal cost = market price. The marginal cost curve will
always intersect the marginal revenue curve before it intersects the
demand curve, because as previously stated, at any given quantity,
marginal revenue i s always less than the market price. Because of this
allocative inefficiency, some consumers will forgo the product because of
its higher price.
Monopolistic competitive firms achieve neither productive nor
allocative efficiency: the greater the different iation of the products, the
greater the inefficiency. However, monopolistic competition creates a
greater variety of products and services, and this greater diversity is more
likely to satisfy consumer tastes, which leads to a more desirable market.
The m onopolistically competitive firm's long -run equilibrium
situation is illustrated in Figure .
Figure 4A. 5
Long -run profit maximization by a monopolistically competitive firm
The entry of new firms leads to an increase in the supply of
differentiated prod ucts, which causes the firm's market demand curve to
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curve will continue shifting to the left until it is just tangent to the average
total cost curve at the profit maximizing level o f output, as shown in
Figure . At this point, the firm's economic profits are zero, and there is no
longer any incentive for new firms to enter the market. Thus, in the
long-run, the competition brought about by the entry of new firms will
cause each firm in a monopolistically competitive market to earn normal
profits, just like a perfectly competitive firm.
Excess capacity. Unlike a perfectly competitive firm, a monopolisti cally
competitive firm ends up choosing a level of output that is below its
minimum efficient scale, labeled as point bin Figure . When the firm
produces below its minimum efficient scale, it is under -utilizing its
available resources. In this situation, the firm is said to have excess
capacity because it can easily accommodate an increase in production.
This excess capacity is the major social cost of a monopolistically
competitive market structure.
4A.8 WASTES OF MONOPOLISTIC
COMPETITION ARE IN BRIEF AS FOLLOWS
(i) Huge expenditure on advertisement: The entrepreneurs in order to
overcome the irrational preferences of the consumers like prejudices,
liking of commodities, or shop or person have to spend large sums of
money on advertisements. This is pure ly a waste from community point of
view.
(ii) Expenditure on cross transportation: Another waste of monopolistic
competition is the expenditure incurred on the cross transportation of the
commodity. For instance, if a commodity produced in New York is ve ry
similar to the commodity produced in Washington, the buyers in
Washington due to their irrational preferences may demand the
commodity produced in New York and vice versa .Had the buyers given
preference to the commodity produced in their own locality, this would
have saved the expenditure on cross transportation of the goods.
(iii) Production of variety of products: Under monopolistic competition,
an industry may not specialize in the production of those commodities for
which it is best fitted. This i s because of fact that it has to spend large sum
of money on advertisement and secondly it has to cut down the prices in
order to attract the customers. So it may find advantageous "to produce
varied assortment of types and qualities to sell to its own par ticular
customers rather than face the cost of attracting a large number of
customers for one type of product alone".
(iv) Existence of inefficient firms: Under monopolistic competition, the
inefficient firms also continue producing the commodities along with the
efficient firms due to irrational preferences of the customers. The
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the inefficient firm. The consumers, thus, suffer monetary loss and the
nation wastage of resources.
(v) Prevents standardization of products: Another wastage of imperfect
competition is that it prevents !he standardization of the commodities.
When goods are standardized, they can be produced on a large scale. In
case of monopolistic competition or imperfec t competition, no producer
would like to produce any design of the commodity on a large scale
because it involves risk. The liking of the design may change and his
goods remain -unsold.
(vi) A firm need not be of the optimum size: Under perfect competitio n,
all the firms in the long run are of optimum size and they are producing at
the lowest average cost. If a firm is not of most efficient size, it will have
to expand its output so that it should produce at minimum average cost.
Under monopolistic competi tion, a firm need not be of the optimum size.
There is no doubt that if it expands its output, the average cost will fall but
then it will have to lower the price as well. The reduction in price may
result in decrease of total revenue. So the firm may not expand its scale of
business. From this, we conclude, that the total number of firms in an
industry, under monopolistic competition, will be greater than under
perfect competition. This is due to the fact that in perfect competition all
the firms are, of t he most efficient size and inefficient firms are
eliminated. While in monopolistic competition, inefficient firms along
with efficient firms continue to exist. The society, thus, pays higher prices
for the products.
Conclusion:
From the above, it should n ot be inferred that monopolistic
competition is sheer wasteful and reduces economic welfare. It has also its
merits. For example, informative advertisement is useful for consumers
and product differentiation provides the consumer a wider choice of
products .
Check your progress:
1. Explain the meaning of monopolistic competition.
2. Discuss the features of monopolistic competition.
3. Derive the demand curve under monopolistic competition.
4. Explain short run equilibrium of a firm under monopolistic compet ition.
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4A.9 OLIGOPOLY MODELS
An oligopoly is defined as a market structure with few firms and
barriers to entry.
Oligopoly = A market structure with few firms and barriers to entry.
There is often a high level of competition between firms, as each firm
makes decisions on prices, quantities, and advertising to maximize profits.
Since there are a small number of firms in an oligopoly, each firm’s profit
level depends not only on the firm’s own decisions, but also on the
decisions of the other firms in the oligopolistic industry. Oligopoly is
defined as a market structure with a small number of firms, none of which
can keep the others from having significant influence. An Oligopoly market
situation is also called ‘competition among the few’. In this article, we will
look at Oligopoly definition and some important characteristics of
thismarket structure .
An oligopoly is an industry which is dominated by a few firms. In
this market, there are a few firms which sell homogeneous or differentiated
products. Also, as there are few sellers in the market, every seller influences
the behavior of the other firms and other firms influence it.Oligopoly is
either perfect or imperfect/differenti ated. In India, some examples of an
oligopolistic market are automobiles, cement, steel, aluminum ,e t c .
4A.9.1Characteristics of Oligopoly
Few firms
Under Oligopoly, there are a few large firms although the exact
number of firms is undefined. Also, ther ei ss e v e r ec o m p e t i t i o ns i n c ee a c h
firm produces a significant portion of the total output.
Barriers to Entry
Under Oligopoly, a firm can earn super -normal profits in the long
run as there are barriers to entry like patents, licenses, control over crucial
rawmaterials ,e t c .T h e s eb a r r i e r sp r e v e n tt h ee n t r yo fn e wf i r m si n t o
theindustry .
Non-Price Competition
Firms try to avoid price competition due to the fear of price wars in
Oligopoly and hence depend on non -price methods like advertising ,a f t e r
sales services ,warranties ,e t c .T h i se n s u r e st h a tf i r m sc a ni n f l u e n c ed e m a n d
and build brand recognition.
Interdependence
Under Oligopoly, since a few firms hold a significant share in the
total output of the industry, each firm is affected by the price and o utput
decisions of rival firms. Therefore, there is a lot of interdependence among
firms in an oligopoly. Hence, a firm takes into account the action and
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Nature of the Product
Under oligopoly, the products of the firms are either homogeneous or
differentiated.
Selling Costs
Since firms try to avoid price competition and there is a huge
interdependence among firms, selling costs are highly important for
competing against rival f irms for a larger market share.
No unique pattern of pricing behavior
Under Oligopoly, firms want to act independently and earn
maximum profits on one hand and cooperate with rivals to remove
uncertainty on the other hand. Depending on their motives, situ ations in real -
life can vary making predicting the pattern of pricing behavior among firms
impossible. The firms can compete or collude with other firms which can
lead to different pricing situations .
Indeterminateness of the Demand Curve
Unlike other mar ket structures, under Oligopoly, it is not possible to
determine the demand curve of a firm. This is because on one hand, there is a
huge interdependence among rivals. And on the other hand there is
uncertainty regarding the reaction of the rivals. The riv als can react in
different ways when a firm changes its price and that makes the demand
curve indeterminate.
4A.10 FIRMS BEHAVIOUR UNDER OLIGOPOLY
Based on the objectives of the firms, the magnitude of barriers to
entry and the nature of government regu lation, there are different possible
outcomes in relation to a firm’s behavior under Oligopoly. These are:
0. Stable prices
0. Price wars
0. Collusion for higher prices
Further, Oligopoly can either be collusive or non -collusive. Collusive
oligopoly is a market si tuation wherein the firms cooperate with each other
in determining price or output or both. A non -collusive oligopoly refers to a
market situation where the firms compete with each other rather than
cooperating.
4A.11 STRATEGIC INTERACTIONS
Each firm mus t consider both: (1) other firms’ reactions to a firm’s
own decisions, and (2) the own firm’s reactions to the other firms’
decisions. Thus, there is a continuous interplay between decisions and
reactions to those decisions by all firms in the industry. Ea ch oligopolist
must take into account these strategic interactions when making decisions.
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firms, these strategic interactions are the foundation of the study and
understanding of oligop oly.For example, each automobile firm’s market
share depends on the prices and quantities of all of the other firms in the
industry. If Ford lowers prices relative to other car manufacturers, it will
increase its market share at the expense of the other a utomobile
companies.
When making decisions that consider the possible reactions of
other firms, firm managers usually assume that the managers of competing
firms are rational and intelligent. These strategic interactions form the
study of game theory, the topic of Chapter 6 below. John Nash (1928 -
2015), an American mathematician, was a pioneer in game theory.
Economists and mathematicians use the concept of a Nash Equilibrium
(NE) to describe a common outcome in game theory that is frequently
used in the s tudy of oligopoly.
4A.11 .1 Nash Equilibrium = An outcome where there is no tendency to
change based on each individual choosing a strategy given the strategy of
rivals.
In the study of oligopoly, the Nash Equilibrium assumes that each
firm makes rational profit -maximizing decisions while holding the
behavior of rival firms constant. This assumption is made to simplify
oligopoly models, given the potential for enormous complexity of strategic
interactions between firms. As an aside, this assumption is one of the
interesting themes of the motion picture, “A Beautiful Mind,” starring
Russell Crowe as John Nash. The concept of Nash Equilibrium is also the
foundation of the models of oligopoly presented in the next three sections:
the Cournot, Bertrand, and Sta ckelberg models of oligopoly.
4A.12 COURNOT MODEL
Augustin Cournot (1801 -1877), a French mathematician,
developed the first model of oligopoly explored here. The Cournot model
is a model of oligopoly in which firms produce a homogeneous good,
assuming th at the competitor’s output is fixed when deciding how much to
produce.
A numerical example of the Cournot model follows, where it is
assumed that there are two identical firms (a duopoly), with output given
by Q i(i=1,2). Therefore, total industry output is equal to: Q = Q 1+Q 2.
Market demand is a function of price and given by Qd=Qd(P), thus the
inverse demand function is P = P(Qd). Note that the price depends on the
market output Q, which is the sum of both individual firm’s outputs. In
this way, each firm’s output has an influence on the price and profits of
both firms. This is the basis for strategic interaction in the Cournot model:
if one firm increases output, it lowers the price facing both firms. The
inverse demand function and cost function are given in Equation 4A1.
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Each firm chooses the optimal, profit -maximizing output level
given the other firm’s output. This will result in a Nash Equilibrium, since
each firm is holding the behavior of the rival constant. Firm One
maximizes profits as follows.
max π1=T R 1–TC1
max π1=P ( Q ) Q 1–C(Q 1)[price depends on total output Q = Q 1+Q 2]
max π1= [40 –Q]Q 1–7Q1
max π1= [40 –Q1–Q2]Q1–7Q1
max π1= 40Q 1–Q12–Q2Q1–7Q1
∂π1/∂Q1= 40 –2Q1–Q2–7=0
2Q1= 33 –Q2
Q1*= 16.5 –0.5Q 2
This equation is called the “Reaction Function” of Firm One. This
is as far as the mathematical solution can be simplified, and represents the
Cournot solution for Firm One. It is a reaction function since it describes
Firm One’s reaction given the output level of Firm Two. This equation
represents the strategic interactions between the two firms, as changes in
Firm Two’s output level will result in changes in Firm One’s response.
Firm One’s optimal output level depends on Firm Two ’s behavior and
decision making. Oligopolists are interconnected in both behavior and
outcomes.
The two firms are assumed to be identical in this duopoly.
Therefore, Firm Two’s reaction function will be symmetrical to the Firm
One’s reaction function (che ck this by setting up and solving the profit -
maximization equation for Firm Two):
Q2*= 16.5 –0.5Q 1
The two reaction functions can be used to solve for the Cournot -
Nash Equilibrium. There are two equations and two unknowns (Q 1and
Q2), so a numerical sol ution is found through substitution of one equation
into the other.
Q1*= 16.5 –0.5(16.5 –0.5Q 1)
Q1*= 16.5 –8.25 + 0.25Q 1
Q1*= 8.25 + 0.25Q 1
0.75Q 1*= 8.25
Q1*= 11
Due to symmetry from the assumption of identical firms:
Qi= 11 i = 1,2Q = 22units P = 18 USD/unit
Profits for each firm are:
πi=P ( Q ) Q i–C(Q i) = 18(11) –7(11) = (18 –7)11 = 11(11) = 121 USD
This is the Cournot -Nash solution for oligopoly, found by each
firm assuming that the other firm holds its output level constant. The
Cournot model can be easily extended to more than tw o firms, but the
math does get increasingly complex as more firms are added. Economists
utilize the Cournot model because is based on intuitive and realistic
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outcomes of the two extreme mark et structures of perfect competition and
monopoly.
This can be seen by solving the numerical example for
competition, Cournot, and monopoly models, and comparing the solutions
for each market structure.
In a competitive industry, free entry results in pr ice equal to
marginal cost (P = MC). In the case of the numerical example, P C= 7.
When this competitive price is substituted into the inverse demand
equation, 7 = 40 –Q, or Q c= 33. Profits are found by solving (P –MC)Q,
orπc=( 7–7)Q = 0. The compet itive solution is given in Equation ( 4A.2).
(4A.2) P c= 7 USD/unitQ c= 33 units πc=0U S D
The monopoly solution is found by maximizing profits as a single firm.
max πm=T R m–TCm
max πm=P ( Q m)Qm–C(Q m)[price depends on total output Q m]
max πm= [40 –Qm]Qm–7Qm
max πm= 40Q m–Qm2–7Qm
∂πm/∂Qm= 40 –2Qm–7=0
2Qm= 33
Qm*= 16.5
Pm= 40 –16.5 = 23.5
πm=( P m–MC m)Qm= (23.5 –7)16.5 = 16.5(16.5) = 272.25 USD
The monopoly solution is given in Equation ( 4A.3).
(4A.3) P m= 23.5 USD/unit Q m= 16.5 uni tsπm= 272.5 USD
The competitive, Cournot, and monopoly solutions can be compared on
the same graph for the numerical example (Figure 4A.6 ).
Figure 4A.6:Comparisons of Perfect Competition, Cournot, and
Monopoly Solutions
The Cournot price and quantity are between perfect competition
and monopoly, which is an expected result, since the number of firms in
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4A.13 DOMINANT FIRM MODEL: PRICE LEADERSHIP
A dominant firm is defined as a firm with a large share of total
sales that sets a price to maximize profits, taking into account the supply
response of smaller firms. The dominant firm model is also known as the
price leadership model. The smaller firms are referred to as the “fringe.”
Let F = fr inge, or many relatively small competing firms in the same
industry as the dominant firm. Let Dom = the dominant firm. The market
demand for the good (D mkt) is equal to the sum of the demand facing the
dominant firm (D dom) and the demand facing the fringe firms (D F).
Ddom=D mkt–DF
Total quantity (Q T) is also the sum of output produced by the dominant
and fringe firms.
QT=Q dom+Q F
The dominant firm model is shown in Figure SF gives the supply
curve for the fringe firms, and the marginal cost of the d ominant firm is
MC dom. Recall that the marginal cost curve is the firm’s supply curve. The
dominant firm has the advantage of lower costs due to economies of scale.
In what follows, the dominant firm will set a price, allow the fringe firms
to produce as m uch as they desire, and then find the profit -maximizing
quantity and price with the remainder of the market.
Figure 4A.7: The Dominant Firm Model
To find the profit -maximizing level of output, the dominant firm
first finds the demand curve facing the dominant firm (the dashed line in
Figure 4A.7 ), then sets marginal revenue equal to marginal cost. The
dominant firm’s demand curve is found by subtracting the supply of the
fringe firms (S F) from the total market demand (D mkt).
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The domi nant firm demand curve is found by the following
procedure. The y -intercept of the dominant firm’s demand curve occurs
where SF is equal to the D mkt. At this point, the fringe firms supply the
entire market, so the residual facing the dominant firm is equa l to zero.
Therefore, the demand curve of the dominant firm starts at the price where
fringe supply equals market demand. The second point on the dominant
firm demand curve is found at the y -intercept of the fringe supply curve
(SF). At any price equal to or below this point, the supply of the fringe
firms is equal to zero, since the supply curve represents the cost of
production. At this point, and all prices below this point, the market
demand (D mkt) is equal to the dominant firm demand (D dom). Thus, the
dashed line below the y -intercept of the fringe supply is equal to the
market demand curve. The dominant firm demand curve for prices above
this point is found by drawing a line from the y -intercept at price (S F=
Dmkt) to the point on the market demand cu rve at the price of the S Fy-
intercept. This is the dashed line above the S Fy-intercept.
Once the dominant firm demand curve is identified, the dominant
firm maximizes profits by setting marginal revenue equal to marginal cost
at quantity Q dom. This leve l of output is then substituted into the dominant
firm demand curve to find the price P dom. The fringe firms take this price
as given, and produce Q F. The sum of Q domand Q Fis the total output Q T.
In this way, the dominant firm takes into account the reac tion of the fringe
firms while making the output decision. This is a Nash equilibrium for the
dominant firm, since it is taking the other firms’ behavior into account
while making its strategic decision. The model effectively captures an
industry with one dominant firm and many smaller firms.
4A.14 CARTELS
Acartel is a group of firms that have an explicit agreement to reduce
output in order to increase the price.
Cartel = An explicit agreement among members to reduce output to
increase the price.
Cartels are illegal in the United States, as the cartel is a form of
collusion. The success of the cartel depends upon two things: (1) how well
the firms cooperate, and (2) the potential for monopoly power (inelastic
demand).
Cooperation among cartel members is limited by the temptation to
cheat on the agreement. The Organization of Petroleum Exporting
Countries (OPEC) is an international cartel that restricts oil production to
maintain high oil prices. This cartel is legal, since it is an international
agreem ent, outside of the American legal system. The oil cartel’s success
depends on how well each member nation adheres to the agreement.
Frequently, one or more member nations increases oil production above
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success is limited by the temptation to cheat. This cartel characteristic is
that of a prisoner’s dilemma, and collusion can be best understood in this
way.
A collusive agreement, or cartel, results in a circular flow of
incentives and beh avior. When firms in the same industry act
independently, they each have an incentive to collude, or cooperate, to
achieve higher levels of profits. If the firms can jointly set the monopoly
output, they can share monopoly profit levels. When firms act tog ether,
there is a strong incentive to cheat on the agreement, to make higher
individual firm profits at the expense of the other members. The business
world is competitive, and as a result oligopolistic firms will strive to hold
collusive agreements togeth er, when possible. This type of strategic
decisions can be usefully understood with game theory
4A.15 NON-COLLUSIVE OLIGOPOLY -SWEEZY’S
KINKED DEMAND CURVE MODEL (PRICE -RIGIDITY)
Usually, in Oligopolistic markets, there are many price rigidities. In
1939, Paul Sweezy used an unconventional demand curve –the kinked
demand curve to explain these rigidities.
4A.15.1 Reason for the kink in the demand curve
It is assumed that firms behave in a two -fold manner in reaction to a
price change by a rival firm. In simple words, firms follow price cuts by a
rival company but not price increases. So, if a seller increases the price of his
product, his rivals do not follow the price increase. Therefore, the market
share of the firm reduces significantly as a result of the price rise. On the
other hand, if a seller reduces the price of his product, then the rivals also
reduce their price to bring it at par with the price reduction of the firm. This
ensures that they prevent their market share from falling. Once the rival s
react, the firm lowering the price first cannot gain from the price cut.
4A.15 .2Why the price rigidity?
As can be seen above, a firm cannot gain or lose by changing its
price from the prevailing price in the market. In both cases, there is no
increase in demand for the firm which changes its price. Hence, firms stick
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Explanation of the Kinked -Demand Curve Model
Figure 4A. 8
In the figure above, KPD is the is the kinked -demand curv ea n d
OP0is the prevailing price in the oligopoly market for the OR product of one
seller. Starting from point P, corresponding to the point OP 1,a n yi n c r e a s ei n
price above it will considerably reduce his sales as his rivals will not follow
his price inc rease.
This is because the KP portion of the curve is elastic and the
corresponding portion of the MR curve (KA) is positive. Therefore, any
price increase will not just reduce the total sales but also his total revenue
and profit. On the other hand, if t he seller reduces the price of the product
below OPQ (or P), his rivals will also reduce their prices.
However, even if his sales increase, his profits would be less than
before. This is because the PD portion of the curve below P is less elastic
and the corresponding part of the marginal revenue curve below R is
negative. Therefore, in both price -raising and price -reducing situations, the
seller is the loser. He will stick to the prevailing market price OP 0which
remains rigid.
4A.15 .3Working of the kin ked-demand curve
Let’s analyze the effect of changes in cost and demand conditions on
price stability in the oligopolistic market. Let’s suppose that the prevailing
price in the market is OP 0.Therefore, if one seller increases the price above
OP0and the r ival sellers don’t and keep the prices of their products at OP,
then it will lead to the product becoming costlier than the others.
Subsequently, the demand for the costlier product will fall significantly. This
is seen in the demand curve of a firm for an yp r i c ea b o v eO P 0or the KP
section of the curve, is relatively elastic. The high elasticity reduces the
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On the other hand, if the seller reduces the price below OP 0,t h e
rivals also follow the price cut to prevent their demand from falling. This is
seen in the demand curve of a firm for any price below OP 0or the PD
segment of the curve is relatively inelastic. The low elasticity does not
increase the demand significantly as a result of the price cut. This
asymmetrical behavioral pattern results in a kink in the demand curve and
hence there is price rigidity in oligopoly markets. The prices remain rigid at
the kink (point P). In other words, the price will remain sticky at OP 0and the
output = OR at th is price.
Due to the difference in the elasticities, the MR curve becomes
discontinuous corresponding to the point of change in elasticity of the
demand curve. The kink represents this. At the output < OR, the demand
curve is KP and the corresponding MR c urve is KA. For output > OR, the
demand curve is PD and the corresponding MR curve is BMR.
4A.16 COLLUSIVE OLIGOPOLY
Sometimes, firms may try to remove uncertainty related to acting
independently and enter into price agreements with each other. This
iscollusion. Collusion is either formal or informal. It can take the form of
cartel or price leadership. Ac a r t e li sa na s s o c i a t i o no fi n d e p e n d e n tf i r m s
within the same industry which follow the common policies relating to price,
output, sale, profit maximiza tion, and the distribution of products. Price
leadership is based on informed collusion. Under price leadership, one firm
is a large or dominant firm and acts as the price leader who fixes the price for
the products while the other firms allow it.
4A.16 .1Collusive Oligopoly Model: Price Leadership Model:
Non-collusive oligopoly model (Sweezy’s model) presented in the
earlier section is based on the assumption that oligopoly firms act
independently even though firms are interdependent in the market. A
vigorous price competition may result in uncertainty. The question that
arises now is: how do oligopoly firms remove uncertainty? In fact, firms
enter into pricing agreements with each other instead of adopting
competition or price war with each other. Such ag reement —both explicitly
(or formal) and implicit (or informal) —may be called collusion.
Always, every firm has the inclination to achieve more strength
and power over the rival firms. As a result, in the oligopolist industry, one
finds the emergence of a few powerful competitors who cannot be
eliminated easily by other powerful firms. Under the circumstance, some
of these firms act together or collude with each other to reap maximum
advantage. In fact, in oligopolist industry, there is a natural tendency f or
collusion. The most important forms of collusion are: price leadership
cartel and merger and acquisition.
When a formal collusive agreement becomes difficult to launch,
oligopolist sometimes operate on informal tacit collusive agreements. Onemunotes.in

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of the mo st common form of informal collusion is price leadership. Price
leadership arises when one firm —may be a large as well as dominant
firm—initiates price changes while other firms follow. An example of
dominant firm price leadership is shown in Fig. 4A.9 where D Tis the
industry demand curve. Since small firms follow the leader —the dominant
firm—they behave as “price -takers”. MCs is the horizontal summation of
the MC curves of all small firms.
Figure 4A. 9
Suppose, the dominant firm sets the price at OP 1(where D Tand
MCs intersect each other at point C). The small firms meet the entire
demand P 1C at the price OP 1. Thus, the dominant firm has nothing to sell
in the market. At a price of OP 3, the small firm will supply nothing. It is
obvious that price will be set in between OP 1and OP 3by the leader.
The demand curve faced by the leader firm of the oligopoly
industry is determined for any price —it is the horizontal distance between
industry demand curve, D T, and the marginal cost curves of all small
firms, MC S.I nF i g . 4A.9 ,D Lis the leader’s demand curve and the
corresponding MR curve is MR L.
Being a leader in the industry, the dominant firm’s supply curve is
represented by the MC Lcurve. Since it enjoys a cost advantage, its MC
curve lies below the MC Scurve. A dominant firm maximizes profit at
point E where its MC Land MR Lintersect each other. The corresponding
output of the price leader is OQ L. Price thus determined is OP 2.S m a l l
firms accept this price OP 2and sell Q LQT(=AB) amount –industry
demand the OQ Toutput. In actual practice, the analysis of price leadership
is complicated, particularly when new firms enter the industry and try to
become the leader or dominant.
4A.16 .2Collusive Oligopoly —Merger andAcquisition:
Another method to remove pric e war among oligopoly firms is
merger. Merger may be defined as the consolidation of two or more
independent firms under single ownership. When a firm purchases assets
of another firm, acquisition takes place. Merger and acquisition take placemunotes.in

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because the management comes to a conclusion that a consolidated firm is
powerful than the sum of individual firms. Since basically the difference
between cartel and merger is a legal one, we won’t consider mergers and
acquisitions. The marginalistic principle applied in the case of profit
maximizing cartel is also applicable in the case of merger.
Conclusion:
Can we make some definite conclusions from the oligopolistic
market structure? Though one can make unambiguous predictions about
perfect competition as well as monopoly, no such predictive element of an
oligopolistic competition exists. It is, thus, a perplexing market structure.
One important characteristic of an oligopoly market is interdependence
among sellers.
Check your progress:
1. State the features of ol igopoly.
2. Explain the concept of Collusive and Non Collusive oligopoly.
3. Discuss dominant firm leadership model.
4. Explain the term Cartel.
4A.17 COLLUSION –MEANING AND EXAMPLES
Collusion occurs when rival firms agree to wor k together –e.g.
setting higher prices in order to make greater profits. Collusion is a way
for firms to make higher profits at the expense of consumers and reduces
the competitiveness of the market.
Figure 4A. 10munotes.in

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In the above example, a competitive in dustry will have price P1
and Q competitive. If firms collude, they can restrict output to Q2 and
increase the price to P2.
Collusion usually involves some form of agreement to seek higher
prices. This may involve:Agreeing to increase prices faced by cons umers.
Deals between suppliers and retailers. For example, vertical price -
fixing e.g. retail price maintenance. (For example, Fixed Book Price
(FBP) set the price a book is sold to the public.
Monopsony pricing –where retailers collude to reduce the amoun t
paid to suppliers. For example, a retailer with great buying power
(Walmart, Amazon) can offer very small profit margins to suppliers as
they have little alternative.
Collusion between existing firms in an industry to exclude new firms
from deals to prev ent the market from becoming more competitive.
Sticking to output quotas and higher prices.
Collusive tendering. For example, ‘cover prices’ for competitive
tendering in bidding for public construction contracts. This is when a
rival firm agrees to set art ificially high price to allow the firm of
choice to win with a relatively high contract offer.
4A.17 .1Types ofcollusion
Formal collusion –when firms make formal agreement to stick to
high prices. This can involve the creation of a cartel. The most famo us
cartel is OPEC –an organisation concerned with setting prices for oil.
Tacit collusion –where firms make informal agreements or collude
without actually speaking to their rivals. This may be to avoid
detection by government regulators.
Price leadershi p. It is possible firms may try to unofficially collude
by following the prices set by a market leader. This enables them to
keep prices high, without ever meeting with rival firms. This kind of
collusion is hard to prove whether it is unfair competition or just the
natural operation of markets.
4A.17 .2Problems of collusion
Collusion is seen as bad for consumers and economic welfare, and
therefore collusion is mostly regulated by governments. Collusion can lead
to:
High prices for consumers. This leads t o a decline in consumer surplus
and allocative inefficiency (Price pushed up above marginal cost)
New firms can be discouraged from entering the market by types of
collusion which act as a barrier to entry.
Easy profits from collusion can make firms lazy a nd avoid innovation
and efforts to increase productivity.
Industry gets the disadvantages ofmonopoly (higher price) but none of
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4A.17 .3 Justification for collusion
In times of unprofitable business conditions, coll usion may be a
way to try and save the industry and prevent firms from going out of
business, which wouldn’t be in the long -term consumer interest. Dairy
suppliers tried to use this justification in 2002/03 after problems from foot
and mouth disease led to a decline in farm incomes.
Research and development : Profits from collusion could, in theory, be
used to invest in research and development.
4A.17 .4Examples of collusion
Milk price bysupermarkets 2002-03
After a period of low milk, butter and cheese p rices, supermarkets
such as Asda and Sainsbury’s colluded with Dairy suppliers, Dairy Crest
and Wiseman Dairies to increase the price of milk, cheese and other dairy
products in supermarkets. After an OFT investigation, supermarkets and
suppliers were fine d a total of £116m.The OFT found prices set by
supermarkets went up by three pence per pint of milk, but the income
received by farmers did not go up. Milk collusion at BBC
Bank loans collusion –RBS andBarclays 2008-2010
In 2010 the OFT found RBS and Ba rclays guilty of collusion in
sharing price arrangements for loans to professionals, such as lawyers and
accountants. Sharing price information is a way to avoid price competition
and keep prices high. RBS was fined £28.59m.
Recruitment agencies forum cartel2004-06
Between 2004 and 2006 six recruitment companies formed a cartel
called the “Construction Recruitment Forum” which met to fix prices for
supplying labour to intermediaries and construction companies. They also
excluded a new firm Parc from any d ealings. Hays was fined £30.4 million
for a ‘Serious breach of competition law.
Collusion intheconstruction industry –collusion ontender price
In bidding for public sector construction work, construction firms
would collude in setting artificially hig h prices. Firms would decide which
contracts they wanted, and rivals would bid purposefully high price. This
is a practice known as “Cover pricing”. Successful companies would often
reward rivals with a secret payment for avoiding competition. During the
investigation, the OFT found 199 offences where the 103 companies
artificially inflated £200m worth of work. Companies were fined a total of
£129.5m by the OFT.
Price fixing inairtravel –British Airways andVirgin 2004-06
In 2007, British Airways was f ined £270m for illegal price -fixing
arrangements with Virgin on long haul flights. The two companies met to
agree and collude on the extra price of fuel surcharges in response to
rising oil prices. Between 2004 and 2006, surcharges on air tickets rosemunotes.in