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1MODULE -I
1
INTRODUCTION TO BUSINESS
ECONOMICS
Unit Structure :
1.0 Objectives
1.1 Meaning, Scope and Importance of Business Economics
1.2 Basic tools in Business Economics
1.3 Basic economic relations -functional relations: equations -
Total, Averag ea n dM a r g i n a lr e l a t i o n s
1.4 Summary
1.5 Questions
1.0 OBJECTIVES
To understand Scope and Importance of Business Economics.
To study the basic tools of Economics.
To explore Basic economic and functional relations.
To understand use of Marginal analysis in decision making.
1.1 MEANING, SCOPE AND IMPORTANCE OF
BUSINESS ECONOMICS
1.1.1 MEANING
Business Economics is also called as Managerial
Economics. It involves application of economic theory and practice
to business. In b usiness ,decision making is ver yi m p o r t a n t .
Decision making is aprocess of selecting one course of action out
ofavailable alternative s.Thus business economics serves as a link
between economic theory and decision -making in the context of
business. Following are few definitions of Bus iness Economics .
Spencer and Siegelman:
It is “the integration of economic theory with business
practice for the purpose of facilitating decision making and forward
planning by management.”
Henry and Hayne:
“Business Economics is economics applied in d ecision
making. It is a special branch of economics. That bridges the gap
between abstract theory and managerial practice.”munotes.in
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2Salvatore:
“Business Economics refers to the application of economic
theory and the tools of analysis of decision science to examin eh o w
an organisation can achieve its objectives most effectively.”
1.1.2 SCOPE OF BUSINESS ECONOMICS
Scope is nothing but the subject matter of business
economics. Scope of Business Economics is very wide.
1)Market Demand and Supply
In economics both demand and supply are the important
forces through which market economy functions. Individual demand
for a product is based on an individual’s choice / Preference s
among different products, price of the product, income etc.
Individual demand is nothing but desire backed by individual’s
ability and willingness to pay. By summing up the demand of all the
consumers or individuals for the product we get market demand for
that particular product. Individual Supply is the amount of a product
that producer is will ing to sell at given prices. By summing up the
supply of all the producers for the product we get market supply for
that particular product. The market price where the quantity of
goods supplied is equal to the quantity of goods demanded is
called as equil ibrium price. Existence, growth and future of
business or firm depends on what price market determines for its
product.
2)Production and Cost Analysis
Knowledge of business economics helps manager to do
production and cost analysis. Production analysis helps to
understand process of production and to make optimum utilisation
of available resources. Cost analysis on the other hand helps firm
to identify various costs and plan budget accordingly. Both
production and cost analysis will help firm to maximize profit.
3)Market structure and Pricing Techniques
Markets are very important in business economics. Study of
markets such as perfect completion, monopoly, oligopoly,
monopolistic market etc. is very significant for producers. It is very
imperative for m anager or producer to identify type of market that
will be there for their products. Knowledge of markets and
competition will help them to take better decision regarding pricing
of the product, marketing strategies etc. Pricing techniques, on the
other ha nd, helps the firms to decide best remunerative price at
different kinds of markets.
4)Forecasting and coverage of risk and uncertainty.
Knowledge of business economics helps manager to
forecast future. For example Demand forecasting. It means
estimation of demand for the product for a future period. Demandmunotes.in
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3forecasting enables an organization to take various decisions in
business, such as planning about production process, purchasing
of raw materials, managing funds in the business, and determining
the pr ice of the commodity. Likewise forecasting future helps firm to
take important decisions and cover risk and uncertainty associated
with those decisions.
5)Inventory Management
Knowledge of business economics will help producer to
reduce costs associated with maintenance of inventory such as raw
materials, finished goods etc.
6)Allocation of resources
Business Economics provides advanced tools such as linear
programming which helps to achieve optimal utilisation of available
resources.
7)Capital Budge ting
Capital budgeting or investment appraisal is an official
procedure used by firms for assessing and evaluating possible
expenses or investments. It is a process of planning of expenditure
which involves current expenditure on fixed/durable assets in r eturn
for estimated flow of benefits in the long run. Investment appraisal
is the procedure which involves planning for determining whether
firm’s long term investments such as heavy machinery, new plant,
research and development projects are worth the fun ding or not.
Knowledge of business economics helps producer to take
appropriate investment decisions with the help of capital budgeting.
1.1.3 IMPORTANCE OF BUSINESS ECONOMICS
1.Knowledge of business economics helps business o rganization
to take important decisions as it deals with application of
economics inreal life situation.
2.It helps manager or owner of firm to design policies suitable for
their firm or business.
3.Business economics is useful in planning future course of
action.
4.It helps to control cos tand monitor profit by doing cost benefit
analysis.
5.It helps in forecasting future for taking important decisions in
present.
6.It helps to set appropriate prices for various products by using
available pricing techniques.munotes.in
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47.It helps to analyse effects of var ious government policies on
business and take appropriate decision.
8.It helps to degree ofefficiency of firms by using various
economic tools.
1.2 BASIC TOOLS IN BUSINESS ECONOMICS
Opportunity cost
Individuals f ace Trade -offs in day to day life. It is a conflicting
situation where people have to make decision or make choice s
among available alternatives. The moment selection takes place,
the counterpart becomes opportunity cost. Opportunity lost is
nothing but opportunity cost. If you decide to attend lec ture,t h e n
you have to sacrifice on time that you could have spent otherwise .
If you plant potatoes in your field, you must forego the chance of
planting another crop because your resources are limited.
Opportunity cost plays very important role in decisi on making.
Doing one thing excludes doing something else. In other words,
when we select something , we pay a cost, which is the cost of not
being able to do the next best thing.
Marginalism
Rational decision makers will always think in terms of
marginal quantities. One should compare the cost of an additional
chocolate with the benefits of an extra chocolate in order to decide
whether to have it or not. Ifthe additional revenue that the producer
is going to get by producing one more car is greater than t he cost of
producing the extra car, only then the sel ler will produce an extra
car.
Let us take one example, an additional car sells for Rs. 10
lacks while it costs only Rs. 8 lakhs to produce the additional car.
Clearly, a rational producer will decide to produce the carbecause
he will make profit of Rs. 2 lakhs per car .O nt h eo t h e rh a n d ,i ft h e
price of car falls to Rs.7 lakhs while the co st of producing it remains
Rs. 8 lakh , it will not make sense to produce the additional car
since the cost surpass esthe revenue to be earned from it. The cost
of producing the extra caris called asmarginal cost while the
revenue obtained from selling an extra caris called asmarginal
revenue. If marginal revenue exceeds marginal cost, it obviously
makes sense to produce the extra car.I ft h em a r g i n a lr e v e n u ei s
less than marginal cost, it not advisable to produce the extra car.
Let us take another example from your day to day life.
Suppose you may score 10additional marks in economics by
studying for entire nig ht.G e t t i n gt h ea d d i t i o n a l 10marks is
important because it makes you feel happy and proud . But suppose
staying up for entire night makes you feel really sleep yi nt h emunotes.in
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5morning hence makes you feel dull and unhappy. In this case,
whether you should study f orentire night depends upon whether
the happiness that you get from the 10additional marks in
economics overshadows the unhappiness caused by the additional
sleeplessness. In this way individuals can make use of marginalism
principal in their day to day life for making appropriate decisions.
Incrementalism
Marginalism represents small unit change in the concerned
variables. But many times in real life situations changes takes place
in chunks or batches. For example firm producing car will not
generally increase its production by one unit, but by a batch of
additional units. Here we use concept of incrementalism instead of
marginalism and decision will be taken by comparing incremental
cost and incremental revenue.
Check your progress :
1)What do you me an by Business Economics?
2)Why knowledge of Business Economics is important?
3)Define opportunity cost.
4)Distinguish between Marginalism & Incrementalism.
1.3 BASIC ECONOMIC RELATIONS -FUNCTIONAL
RELATIONS: EQUATIONS -TOTAL, AVERAGE AND
MARGINAL RELATIONS
The Relationship between Total, Average and Marginal can
be explained with the help of concepts like utility, cost, revenue etc.
Here we will take example of revenue concepts.
Where, P = Price & Q = Quantity
TR = Total Revenue
AR = Average Revenue
MR = Marginal Revenuemunotes.in
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6Quantity Price TR AR MR
1 30 30 30 30
2 28 56 28 26
3 26 78 26 22
4 24 96 24 18
5 22 110 22 14
6 20 120 20 10
7 18 126 18 6
8 16 128 16 2
9 14 126 14 -2
10 12 120 12 -6
Table 1.1
Total revenue is calculate d by multiplying price and quantity.
As quantity increases TR increases initially then it decreases. AR is
same as price . MR decreases constantly and becomes negative
eventually.
Important concepts
1.Variables
A variable is magnitude of interest that can be measured.
Variables can be endogenous and exogenous variables. Variables
can be independent and dependent.
2.Functions
Function shows existence of relationship between two or
more variables. It indicates how the value of one variable depends
on the val ue of another one. It does not give any direction of
relation.
3.Equations
An equation specifies the relationship between the
dependent and independent variables . It specifies the direction of
relation.
4.Graph
Graph is a geometric tool used to express the relationship
between variables. Itis a pictorial representation of data which
shows how two or more sets of data or variables are related to one
another.munotes.in
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75.Curves
The functional relationship between the variables specified in
the form of equatio ns can be shown by drawing line or outline
which gradually deviates from being straight for some or all of its
length in the graph.
6.Slopes
Slopes show how fast or at what rate, the dependant
variable is changing in response to a change in the independent
variab le.
1.4SUMMARY
In this unit we have seen meaning, scope and importance of
business economics. Business Economics is also called as
Managerial Economics. It involves application of economic theory
and practice to business. In business, decision making i sv e r y
important. Decision making is a process of selecting one course of
action out of available alternatives. Thus business economics
serves as a link between economic theory and decision -making in
the context of business. Scope of business economics inv olves
Market Demand and Supply, Production and Cost Analysis, Market
structure and Pricing Techniques, Forecasting and coverage of risk
and uncertainty, Inventory Management, Allocation of resources,
Capital Budgeting etc. We have also discussed basic tool si n
economics such as opportunity cost, marginalism and
incrementalism. Business economics deals with many economic
relations and various concepts such as variables, functions,
equations, graph, curves and slopes.
1.5QUESTIONS
1)Discuss scope and importa nce of business economics.
2)Write short note on Opportunity Cost.
3)Write short note on Marginalism
4)Discuss use of marginal analysis in decision making.
5)Write short note on Incrementalism .
6)Explain following concepts -
a.Variables
b.Functions
c.Equations
d.Graph
e.Curves
f.Slopes
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8MODULE -II
2
MARKET DEMAND AND MARKET
SUPPLY
Unit Structure :
2.0 Objectives
2.1 The basics of market demand, mark et supply and
equilibrium price
2.2 Shifts in the demand and supply curves and equilibrium
2.3 Summary
2.4 Questions
2.0 OBJE CTIVES
1)To study the basics of market demand, market supply and
equilibrium price.
2)To study shifts in the demand and supply curves and
equilibrium.
2.1 MARKET DEMAND, MARKET SUPPLY AND
EQUILIBRIUM PRICE
In economics both demand and supply are the impor tant
forces through which market economy functions. Individual’s
demand is desire backed by his / her ability and willingness to pay.
There is an indirect or negative relationship between price and
quantity demanded. Individual Supply is the amount of a pr oduct
that producer is willing to sell at given prices. There is a direct or
positive relationship between price and quantity supplied.
Market Demand
Individual demand for a product is based on an individual’s
choice / Preference among different products, price of the product,
income etc. Individual demand is nothing but desire backed by
individual’s ability and willingness to pay. By summing up the
demand of all the consumers or individuals for the product we get
market demand for that particular product.munotes.in
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9Table 2.1 Market Demand Schedule
Price Demand of
Individual ADemand of
Individual
BMarket Demand
(Demand of Individual A +
Demand of Individual B)
10 5 7 12
20 4 6 10
30 3 5 8
40 2 4 6
50 1 3 4
The above table 2.1 represents demand schedule of
individual A, individual Band Market Demand. Same schedule can
be represented with the help of agraph.
Diagram 2.1 Market Demand Curve
Diagram 2.1 represents demand curve of individual A, individual B
and Market Demand. DA is a demand curve of ind ividual A. DB is
thedemand curve of individual B. DM isthemarket demand curve.
All curves are downward sloping indicating negative relationship
between price and quantity demanded.munotes.in
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10Market Supply
Individual Supply is the amount of a product that produ ceris
willing to sell at given prices. By summing up the supply of all the
producers for the product we get market supply for that particular
product.
Table 2.2 Market Supply Schedule
Price Supply of
Producer ASupply of
Producer BMarket Supply
(Supply of Producer A +
Supply of Producer B)
10 1 3 4
20 2 4 6
30 3 5 8
40 4 6 10
50 5 7 12
The above table 2.2 represents supply schedule of producer
A,producer B and Market supply . Same schedule can be
represented with the help of ag r a p h .
Diagram 2.2 Market Supply Curve
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11Diagram 2.2 represents supply curve of producer A,
producer B and Market supply. SA is a supply curve of producer A.
SB is the supply curve of producer B.SMisthemarket supply
curve. All curves are upward sloping indicating posi tive relationship
between price and quantity demanded.
Equilibrium Price
The market price where the quantity of goods supplied is
equal to the quantity of goods demanded is called as equilibrium
price . This is the point at which the market demand and mark et
supply curves intersect s.
Table 2.3 Equilibrium Price Schedule
Price Market Demand Market Supply
10 12 4
20 10 6
30 8 8
40 6 10
50 4 12
The above table 2.3 represents schedule of equilibrium
price. Same schedule can be represented with the help of a graph
to locate equilibrium price. Even in the table itself it is very clear
that 30 is equilibrium price as at this price ,market demand is equal
to market supply i.e. 8 units.
Diagram 2.3 Equilibrium Price.
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12Diagram 2.3 represents Equilibrium Pri ce.DMis the market
demand curve. D Mis downward sloping curve indicating inverse or
negative relationship between price and quantity demanded. S Mis
the market supply curve. SMis upward sloping curve indicating
direct or positive relationship between pr ice and quantity supplied.
DMa n d SMcurves intersect each other at point E where
equilibrium price is 30 and equilibrium quantity demanded and
supplied is 8 units.
Check your Progress :
1)What do you mean by Individual Demand & Market Demand?
2)What d o you mean by Individual Supply & Market Supply?
3)Define Equilibrium Price.
2.2 SHIFTS IN DEMAND AND SUPPLY CURVES AND
EQUILIBRIUM
2.2.1 SHIFTS / CHANGES IN DEMAND :
Shifts in demand takes place due to changes in non-price
factors such as income, population, government policies, tastes,
preferences, habits, fashion etc. Whenever there are favourable
changes in these factors the n the demand curve shifts outward. It is
also known as Increase in Demand. Whenever there are
unfavourable changes in these factors then the demand curve
shifts inward. It is also known as Decrease in demand .
Diagram 2.4 Changes in Demand
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13In the above diagram D is the original demand curve. At
price P, OQ quantity is demanded. If there are favourable changes
in the non-price factors affecting demand then the demand curve
shifts outward and becomes D1. Here we can see that at same
price P, now more quantity i.e. OQ1 quantity is demanded. If there
are unfavourable changes in the non -price factors affecting demand
then the demand curve shifts inward and becomes D2. Here we
can see that at same price P, now less quantity i.e. OQ2 quantity is
demanded. Shift from D to D1 is known as Increase in Demand and
shift from D to D2 is known as Decrease in Demand.
2.2.2SHIFTS /CHANGES IN SUPPLY
Shifts in supply takes place due to changes in non -price
factors such as cost of production, government policies, state of
technology etc. Whenever there are favourable changes in these
factors then the supply curve shifts outward. It is also known as
Increase in supply. Whenever there are unfavourable changes in
these factors then the supply curve shifts inward. It is also known
as Decrease in supply.
Diagram 2.5 Changes in Supply
In the above diagram S is the original supply curve. At price
P, OQ quantity is supplied. If there are favourable changes in the
non-price factors affecting supply then the supply curve shifts
outward and becomes S1. Here we can see that at same price P,
now more quantity i.e. OQ1 quantity is Supplied .I ft h ere are
unfavourable changes in the non -price factors affecting supply then
thesupply curve shifts inward and becomes S2. Here we can see
that at same price P, now less quantity i.e. OQ2 quantity is
supplied .Shift from S to S 1 is known as Increase in Supply and
shift from S to S 2 is known as Decrease in Supply .munotes.in
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142.2.3 SHIFTS IN EQUILIBRIUM
The market price where the quantity of goods supplied is
equal to the quantity of goods demanded is called as equilibrium
price. This is the point at which the market demand and market
supply curves intersects. Whenever there are changes in demand
and supply, position of equilibrium will change.
Diagram 2.6 Effects of Changes in Demand on Equilibrium
In the above diagram D is the original demand curve and S
is the original Supply curve. At equilibrium E, equilibrium price is P
and equilibrium quantity demanded and supplied is OQ. If there are
favourable changes in the non -price factors affecting demand then
the demand curve will shift outward and become D1. Now th en e w
equilibrium is atE1. At E1, equilibrium price is P1 and equilibrium
quantity demanded and supplied is OQ1. If there are unfavourable
changes in the non -price factors affecting demand then the demand
curve will shift inward and become D2. Now the new equilibrium is
atE2. At E2, equilibrium price is P2 and equilibrium quantity
demanded and supplied is OQ2. Thus increase in demand leads to
higher price and decrease in demand leads to lower prices.munotes.in
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15Diagram 2.7 Effects of Changes in Supply on Eq uilibrium
In the above diagram D is the original demand curve and S
is the original Supply curve. At equilibrium E, equilibrium price is P
and equilibrium quantity demanded and supplied is OQ. If there are
favourable changes in the non -price factors af fecting supply then
the supply curve will shift outward and become S1. Now the new
equilibrium is at E1. At E1, equilibrium price is P1 and equilibrium
quantity demanded and supplied is OQ1. If there are unfavourable
changes in the non -price factors affect ing supply then the supply
curve will shift inward and become S2. Now the new equilibrium is
at E2. At E2, equilibrium price is P2 and equilibrium quantity
demanded and supplied is OQ2. Thus increase in supply leads to
lower price and decrease in supply le ads to higher prices.
Check you Progress :
1)List out the factors that lead to changes in demand.
2)List out the factors that lead to changes in supply.
2.3SUMMARY
In economics both demand and supply are the important
forces through whic h market economy functions. Individual demand
for a product is based on an individual’s choice / Preference among
different products, price of the product, income etc. Individual
demand is nothing but desire backed by individual’s ability and
willingness t o pay. By summing up the demand of all themunotes.in
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16consumers or individuals for the product we get market demand for
that particular product. Individual Supply is the amount of a product
that producer is willing to sell at given prices. By summing up the
supply of all the producers for the product we get market supply for
that particular product. The market price where the quantity of
goods supplied is equal to the quantity of goods demanded is
called as equilibrium price. Existence, growth and future of
business o rf i r m depend on what price market determines for its
product. In this unit we studied derivation of individual and market
demand and supply curves along with derivation of equilibrium
price and quantity. We have also seen how shifts in demand and
supply t akes place along with their effect on equilibrium level of
price and quantity.
2.4QUESTIONS
1)Write short note on Market Demand.
2)Write short note on Market Supply.
3)Write short note on Equilibrium Price.
4)Complete the following table and draw the graph.
Price Demand of Individual
ADemand of Individual
BMarket
Demand
10 15 10 ?
20 14 9 ?
30 13 8 ?
40 12 7 ?
50 11 6 ?
5)Complete the following table and draw the graph.
Price Supply of Producer A Supply of Producer B Market Supply
10 8 6 ?
20 9 7 ?
30 10 8 ?
40 11 9 ?
50 12 10 ?
6)Write short note on changes in Demand.
7)Write short note on changes in supply.
8)What are the effects of changes in Demand on equilibrium?
9)What are the effects of changes in Supply on equilibrium?
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17MODULE -III
3
DEMAND ANALYSIS AND DEMAND
ESTIMATION AND FORECASTING
Unit Structure :
3.0 Objectives
3.1 Introduction
3.2 Demand function
3.3 Determinant of demand
3.4 Meaning of demand
3.5 Law of demand
3.6 Nature of deman d curve under different mark ets
3.7 Elasticity of demand
3.8 Price elasticity of demand
3.9 Factors affecting price elasticity
3.10 Measures of price elasticity
3.11 Degree s of price elasticity of demand
3.12 Income elasticity of demand.
3.13 Cross elasticity of demand.
3.14 Promotio nal elasticity of deman d
3.15 Concepts of revenue.
3.16 Meaning
3.17 Significance of demand forecasting
3.18 Steps in demand forecasting
3.19 Methods in demand forecasting
3.20 Summary
3.21 Question
3.0OBJECTIVES
To understand the demand and its fu nction.
To study the various factors which determines the demand.
To familiarise with the various concepts of elasticities of
demand.
To understand with the concepts of revenue.
To understand the meaning and sig nificance of demand
forecasting
To learn th e steps, involve i n estimating demand forecasting
To understand th e methods of demand forecastingmunotes.in
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183.1INTRODUCTION
In economics both demand and supply are the important
forces through which market economy functions. The demand
function shows the relations hip between the quantity demanded
and its various determinants. In this chapter we will explain the
demand function in detail and the nature of demand curve under
different market situation. We will also explain the relationship
between elasticity of deman d and revenue concepts.
Business is a serious job. Manager or the business firms has
to take certain decision to run their business smoothly without any
disturbance in his business. Demand forecasting play a vital role in
business planning. Business enter prises need to plan their
activities. Most of the business decisions of a firm under an
organization are made under the conditions of risk and uncertainty.
Demand forecasting is a systematic process that involves
anticipating the demand for the product and services of an
organization in future under a set of uncontrollable and competitive
forces in the economy.
Demand forecasting helps the business firms to take
appropriate decision about the production and the use of factors of
production to fulfil the fu ture demand of the commodity.
3.2 DEMAND FUNCTION
Demand function is an arithmetic expression that shows the
functional relationship between the demand for a commodity and
the various factors affecting it. This includes the income of a
consumer and the p rice of a commodity along with other various
determining factors affecting demand. The demand for a
commodity is the dependent variable, while its determinants factors
are the independent variables.
The demand for a commodity depends on various factors
which determines the quantity of a commodity demanded by
various individuals or a group of individuals. The following equation
shows the demand function which expresses the relationship
between the quantity demanded of a commodity X and its
determinants.xx yQd = f P ,Y, P ,T, AWhere,xQd= Quantity demanded of commodity X.xP= Price of commodity X.munotes.in
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19Y= income of a consumer.yP= Price of related commoditie s.T= Taste and Preference of an individual consumer.A=A d v e r t i n ge x p e n d i t u r em a d eb yp r o d u c e r .
3.3 DETERMINANTS OF DEMAND
The important determinants of demand for a commodity are
explained below:
1.Price of commodity (P x):The price of commodity is very
important determinants of demand for any commodity. Other
things remaining same, the rise in price of the commodity, the
demand for the commodity contracts, and with the fall in price,
its demand expands . So, the quantity demanded and price
shows an inverse relationship in thecase of normal goods. In
other word changes in price brings changes in the consumer’s
demand for that commodity.
2.Income (Y): Another important determinant of demand for a
commodity is consumer’s income. Change in consumer’s
income also influences the change in consumer ’sdemand for a
commodities. The demand for normal goods increases with the
increasing level of income and vice versa. it shows a direct
relationship between income an dq u a n t i t yd e m a n d e d .
3.Price of related commodities (P y):The demand for a
commodity is also affected by the price of other commodities,
especially of substitute or complementary goods. Ag o o d may
have some related goods either substitute or complementary.
The relation between two may be different.
Substitute Goods :Substitute Goods arethose goods which can
be substituted from each other. For Instance Tea & Coffee .When
the rise in the price of Tea causes rise in demand for Coffee
because there is no cha nge in price of coffee such goods are called
as substitute goods. In other words the relation between two
substitute goods are positive. An incase the price of one commodity
increase the demand for other.
Complementary Goods :Complementary goods are thos eg o o d s
which one purchased together .For Instance Car & Petrol .when
their a rise in price of Petrol leads to fall in demand for Car such
goods are called complementary good. In other words, the relation
between two complementary goods are negative. An in crease in
price of one commodity leads to decrease in demand for other.munotes.in
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204.Taste and Preference (T): The demand for a commodity also
depends on the consumer’s taste and preferences such as
change in fashion, culture, tradition etc. As the consumers taste
and preference for a particular commodity changes the demand
for that particular commodity also changes. Therefore, Taste
and Preference of a consumer plays an important role.
5.Advertising expenditure (A): Advertising expenditure by a firm
influence the d emand for a commodity. The advertisements by
the manufacturer and sellers attract more customers towards
the commodity. There exists positive relationship between
advertising expenditure and demand for the commodity.
3.4MEANING OF DEMAND
The demand i n economics means the desires to purchase
the commodity backed by willingness and the ability to pay for it.
Demand= Desire + Willingness to buy + Ability to pay
3.5 THE LAW OF DEMAND
The law of demand was propounded by the famous
economist Alfred Mars hall in early 1892. Due to the general
observation of law, economists have come to accept the validity of
the law under most situations. The law of demand states that other
thing being equal the relationship between the price and the
quantity demanded of a commodity are inversely related to each
other. In other words, when the price of a commodity rises the
quantity demand for the commodity falls. The law of demand helps
to explain the consumer’s choice behaviour due to change in the
price of a commodity.
Assumptions:
The law of demand is based on the following assumption given
below:
1.No change in consumers income: There should not be any
change in the consumer income while operating under the law
of demand. If income of a consumer increase sthe consumer
may buy more goods at the same price or buy the same
quantity even if price increases. The income is assumed to be
constant, as it may lead to enticement tothe consumer to buy
more goods and raise thedemand for a commodity despite an
increase in the price of commodity.
2.No change in the price of other goods: The price of substitute
goods and complimentary good should remain the same. If any
of the price changes may lead to change in the demand for themunotes.in
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21other commodity and it will change the consumer preferenc ew i l l
affect the law of demand.
3.No change in taste and preference: The law assumes that the
consumer’s taste and preference for a commodity remains the
same. If there is a change in consumer’s taste and preferences
there will be a change in the demand for the commodity.
4.No expectation of change in the future price: The law of
demand remains valid if there is no change in future expectation
about price of commodities. If consumer is expecting rise in
price in future, he will buy more quantities even at a h igher price
in present time and vice -versa.
5.No change in the size and composition of population: The
law also assumes that the size and composition of the total
population of a country should not change. That means, the
population must neither increase nor decrease. Because a rise
in the populations would increase the demand for commodities.
Along with the size of population, composition of population also
matters. If number of senior citizens is more then the demand
for medical care will be more. If female population is more then
the demand for cosmetics will be more.
6.No change in government polices: The law assumes that
there is no change in the government policy which will either
increases or decreases the demand for the commodity.
Demand Schedule and De mand Curve:
The law of demand can be simply explained through a
demand schedule and demand curve. The demand schedule is a
tabular representation of the law of demand which is shown below:
Demand Schedule: Table 3.1
Price (`) Quantity demanded of a commod ity ‘X’
(Units)
50 10
40 20
30 30
20 40
10 50
Representation of table:
It can be seen from the above table, that when theprice of a
commodity ‘X’ is `50 per unit, the consumer purchases 10 units of
the commodity. Further when the price of the commo dity falls to
`40, he purchases 20 units of commodity. Similarly, when the price
falls further the quantity demand by the consumer goes on
increasing by 30 units as so on. This demand schedule shows the
inverse relationship between the price and quantity d emanded of a
commodity.munotes.in
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22Demand curve:
Quantity Demand
Diagram 3.1
The demand schedule can also be explained through
demand curve in a simpler way. The demand curve is a graphical
representation of the quantities of good demanded by the
consumer at vari ous possible price in a period of time. The Diagram
shows quantity demanded on X -axis and the price of a commodity
on Y -axis. If the demand schedule is plotted on the demand curve,
we get the various price -quantity combination points and if we join
these p oints, we get the downward slopping demand curve. Thus,
the downward sloping demand curve according to law of demand
shows, the inverse relationship between price and quantity
demanded.
Exceptions to the Law of Demand: The law of demand is
generally valid in most of the cases but there are few cases where
the law is not applicable. Such cases are explained below:
1.Goods having prestige value (Veblen effect): This exception
to the law of demand was propounded by an economists
Thorstein Veblen in his work ‘c onspicuous consumption’.
According to him, some consumer measures the utility of a
commodity by its price i.e., the higher the price of a commodity,
the higher its utility. For example, People sometimes buy certain
expensive or prestigious goods like diamo nds at high prices not
due to their intrinsic value but only because it has snob value.
On the other hand, as price falls, they demand less due to the
loss of its snob value. This effect is called as Veblen effect or
Snob value.
2.Giffen goods: Another excep tion to the law of demand was put
forwarded by the economists Sir Robert Giffen. There is a directmunotes.in
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23price –demand relationship in case of giffen goods. When with
the rise in the price of a giffen goods, its quantity demand
increases and with the fall in it s price its quantity demand
decreases, the demand curve will slope upward to the right
hand side and not downward.
3.Price Expectations: When the consumer expects there is rise
in price of a commodity in future, he/she may purchase more of
commodity at pres ent. Where the law of demand is not
applicable.
4.Emergencies: During the time of emergencies such as natural
and man -made calamities, the law of demand becomes
ineffective. In such circumstances, people often fear the
shortage of the necessity goods and hen ce demand more
goods and services even at higher prices.
5.Change in fashion and taste &preferences: The change in
taste and preferences of the consumers denies the effect of law
of demand. The consumer tends to buy those commodities
which are in trends in t he market even at higher prices. On the
other hand, when a product goes out of fashion, a reduction in
the price of the product may not increases the demand for it.
Check your Progress :
1)Who propounded the theory of law of demand?
2)What relationsh ip does law of demand state between demand &
price?
3)What is Veblen effect?
3.6NATURE OF DEMAND CURVE UNDER DIFFERENT
MARKETS
Economist have classified the various markets prevailing in a
capitalist economy into (a) perfect competition or p ure competition,
(b) monopolistic competition, (c) oligopoly and (d) monopoly.
According to Cournot, a French economist, “Economist understand
by the term market not any particular market place in which things
are bought and sold but the whole of any regio n in which buyers
and sellers are in such free interaction with one another that the
price of the same good tends to equality easily and quickly’’. The
type of different market depends on number of factors. Accordingly,
the nature of demand curve is differ ent in different market. Themunotes.in
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24nature of demand curve under various market structure are as
follows:
Demand Curve in Perfect Competition:
Perfect competition is said to prevail when there are large
number of producers (firms) producing and selling homogeno us
product. The maximum output produce by the individual firm is very
small relatively to the total demand to the industry product so that
firm cannot affect the price by varying its supply of output. The
seller is the price taker he accepts the price dete rmined in the
market by market demand and market supply. Thus, the individual
price under perfect competition is determine by the market demand
and market supply.
Market Demand Curve: The market demand curve under perfect
competition is downward sloping. Because price and quantity
demand are inversely related to each other as the price of a
commodity increases the demand for that good decreases. The
market price at which the firms will sell their commodity is
determined by the interaction of market demand and market supply.
Once the market determines the price for the commodity all firms
will fix their price equals to market price as they are price taker
under the perfect competition. Thus, the individual demand curve is
equal to the equilibrium price of th e market. The Diagram 3.2.
shows the market demand curve which is downward sloping and P 0
is the equilibrium market price which is followed by all the individual
firm and the individual firm is facing the horizontal demand curve.
Diagram 3.2
Individ ual Firm demand curve: Demand curve facing an
individual firm working under prefect competition is perfectly elastic
i.e. a horizontal straight line parallel to X axis at a given price which
is determined by the market demand sand market supply. The
Diagra m3.3 shows Qty demanded on X axis and Price of themunotes.in
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25commodity on Y axis. Where OP 1is the price determined by the
interaction of market demand and market supply curve. It shows if
firm tries to lower the price, he will get negative profit.
Diagram 3.3
Demand Curve under Monopoly: Monopoly is a market where
there is single firm producing and selling product which has no
close substitute. As being the single seller monopoly has a control
on supply and he can also decide the price of a commodity. But
howev er, a rational monopolist who aim at maximum profit will
control either price or supply. As monopolists is the only single
seller in the market, he constitutes the whole industry. Therefore,
the demand curve under monopoly market is downward sloping
and ha s a steeper slope as shown in the Diagram 3.4. below:
Diagram 3.4
Thus, in monopoly there is a strong barrier to entry new firm
in the industry. If the monopolist firm wants to increases the sale in
the market, he has to lower the price of its commodi ty.
Demand curve under Monopolistic competition: In the
monopolistic market there is a large number of firms producing or
selling somewhat differentiated product which have closemunotes.in
Page 26
26substitute. As a result, demand curve facing a firm under
monopolistic comp etition is sloping downward and has a flatter
shape which is highly elastic and this indicate that a firm enjoy
some control over the price of a commodity. The demand curve
facing an individual firm under monopolistic competition is shown in
the following Diagram 3.5.
Diagram 3.5
Demand curve under oligopoly market :Oligopoly is a market
where there are few firms or sellers producing or selling
differentiated products. The fewness of firm ensures that each of
them will have some control over the price of the product and the
demand curve facing each other will be downward sloping which
indicates the price elasticity of demand for each firm will not be
infinite. As there are interdependence of firm. Any decision
regarding change in the price of output at tracts reaction from the
rival firms. Therefore, the demand curve for an oligopoly firm is
indeterminate, i.e. it cannot be drawn accurately as exact behaviour
pattern of a producer with certainty.
The demand curve faced by the firm under oligopoly is
shown in the following Diagram 3.6:munotes.in
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27
Diagram 3.6
The demand curve facing an oligopolist is kinked in nature.
The kink is formed at a prevailing level the point K because the
segment of the demand curve above the prevailing price level i.e.
Kd is highly e lastic and the segment the segment below the
prevailing price level i.e. Kd 1is inelastic. This is due to different
reaction of the different firm.
3.7ELASTICITY OF DEMAND
Elasticity of demand helps us to estimate the level of change
in demand with re spect to a change in any of the determinants of
demand. The concept of elasticity of demand helps the firm or
manager in decision making with respect to pricing, promotion and
production polices. It has a very great importance in economic
theory ss well fo r formulation of suitable economic policy.
Meaning of elasticity:
Elasticity is the measure of the degree of responsiveness of
change in one variable to the degree of responsiveness change in
another variable.
Thus, Elasticity =% change in A% change in BThe concept of elasticity of demand therefore refers to the
degree of responsiveness of quantity demanded of a good to the
change in its price, consumers income and price of related goods.munotes.in
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28Check your Progress :
1)In which market condition market demand & market supply
determines the price of commodity?
2)Why Oligopoly demand Curve is kinked?
3)What is Elasticity?
3.8PRICE ELASTICITY OF DEMAND
Price elasticity of demand shows the degree of
responsiveness of quantity demanded of a g ood to the change in its
price, other factors such as income, prices of related commodities
that determines demand for the commodity which are held
constant. In other words, price elasticity of demand is defined as
the ratio ofthe percentage change in qua ntity demanded of a
commodity to a percentage change in price of the commodity.
Thus,
ep=Percentage change in quantity demanded
Percentage change in price
The demand curve for most of the commodities, is
downward sloping due to the inverse relationship between quantity
demanded and price of the commodity, the value of the price
elasticity o fdemand will always be negative. While interpreting the
price elasticity of demand the negative sign is ignored or omitted.
This is because we are interested in meas uring the magnitude of
responsiveness of quantity demanded of a good to changes in its
prices.
3.9 FACTORS AFFEC TING PRICE ELASTICITY OF
DEMAND
The price elasticity of demand depends upon number of
factors which affects its elasticity. They are as follow s:
a.Nature of goods or commodity: The elasticity of demand for a
commodity depends upon the nature of the commodity, i.e.,
whether the commodity is a necessary, comfort or luxury good.
The elasticity of demand for a necessary commodity is relatively
small . For example, if the price of such a good rise, its buyersmunotes.in
Page 29
29generally are not able to reduce its demand as its necessity
commodity.
The elasticity of demand for a luxury good is usually high.
This is because the consump tion of a such good, unlike that of a
necessary commodity, can be delayed. That is why if the price of
such a commodity increase, the demand for the good can be
significantly reduced.
b.Availability of Substitute Goods: The price elasticity of
demand also depends upon the substitution of goo ds. If there is
a close substitute for a particular commodity in the market, then
the demand for such commodity would be relatively more
elastic. For example, since tea and coffee are close substitute
for each other in the commodity market, a rise in the p rice of
coffee will result in a considerable fall in its demand and a
consequent rise in the demand for tea. Therefore, a demand for
coffee will be relatively more elastic because of the availability
of tea in the market.
c.Alternative and Variety of Uses o f the Product: as we know
that the resources have an alternative use. The demand for
such goods has many uses. The more the alternative and
variety of uses of a good, the more would be its elasticity of
demand. For example, Electricity is used for many pur poses
such as lighting, heating, cooking, ironing and also use as a
source of power in many industries &h o u s e h o l d s .T h a ti sw h y
when the price of electricity increases, its demand will decrease
and vice versa.
d.Role of Habits and custom: i f the consumer h as a habit of
something, he will not reduce his consumption even if the price
of such commodity increases thedemand for them do not
decreases considerably and so their elasticity of demand will be
inelastic. Ex; Alcohol, Cigarettes which are injurious for health
but people still consume it because of their habit.
e.Income Level of the consumer: The elasticity of demand
differs due to the change in the income level of the households.
Elasticity of demand for a commodity is low for higher income
level groups then the people with low incomes. This is because
rich people are not influenced much by changes in the price of
goods. Poor people are highly affected by the increase or
decrease in the price of goods. As a result, demand for the
lower income group is highly elastic in demand.
f.Postponement of Consumption: if the consumer postponed
the consumption of commodity in future the demand is relatively
elastic. For example, commodities whose demand is not urgent,munotes.in
Page 30
30have highly elastic demand as their consumption ca nb e
postponed if there is an increase in their prices. However,
commodities with urgent demand like medicines have inelastic
demand because it is an essential commodity whose
consumption cannot be post pended.
g.Time Period: Price elasticity of demand is related to a period of
time. The elasticity of demand varies directly with the time
period. In the short run the demand is generally inelastic and in
long-run it becomes relatively elastic. This is because
consumers find it difficult to change their habit s, in the short run,
in order to response to the change in the price of the
commodity. However, demand is more elastic in long run as
their other substitutes available in the market, if the price of the
given commodity rises.
3.10 MEASUREMENTS OF PRICE EL ASTICITY OF
DEMAND
There are various methods of measuring price elasticity of
demand some of the important methods are explained below:
A.Percentage method: This method is associated with the name
of Dr Alfred Marshall. This method is known by various name s
such as Proportionate method, Ratio method, Arithmetic
method, and Flux method. The price elasticity of demand in this
method is measured by dividing percentage change in quantity
demanded by the percentage change in the price. In other it is
the ratio o f the percentage change in quantity demanded of a
commodity by the percentage change in the price of the
commodity itself.
Thus,
Ep= Percentage change in quantity demanded
Percentage change in price
Symbolically, Ep =
÷
=
Where, q = original quantity demanded.
p=o r i g i n a lp r i c e .
Δq = change in quantity demanded.
Δ p= change in price.
As mentioned above, the price elasticity of demand has a
negative sign this is due to inverse relationship between price and
quantity demanded. But for simplicity in understanding themunotes.in
Page 31
31magnitude or the degree of responsiveness we ignore the negative
sign and take only numerical value of elasticity.
B.Point method: Prof. Marshall devised a geometrical method
for measuring the elasticity of demand at a point on the demand
curve. In o ther word, the point elasticity of demand measures
the elasticity of demand at the point on the demand curve.
This can be illustrated by the following given example:
Table 3.2
Price of
commodity XQuantity
demanded of XPoint
20
1560
90A
B
The above table is represented in the following Diagram 3.7.
Diagram 3.7
The elasticity is at point A & B
Elasticity at point A =//qqpp30 / 605 / 2030 105 601.10munotes.in
Page 32
32Elasticity at point B30 / 905/530 55 900.33
C.Arc ela sticity of demand: In the above measure we have
studied the measurement of elasticity at a point on a demand
curve. When elasticity is measured between two points on the
same demand curve, it is known as arc elasticity. According to
Prof. Baumol, “Arc elas ticity is a measure of the average
responsiveness to the change in price exhibited by a demand
curve over some finite stretch of the demand curve.”. Any two
points on the same demand curve make an arc shows the arc
elasticity of demand. In other words, arc price elasticity of
demand measures elasticity of demand at two points on the
demand curve.12 1 222qpEpqq p p
21 2 1
21 2 1
21 2 1
21 2 190 60 15 2015 20 90 6030 35
5 150
1.39
qq p p
qq p p
qq p p
ppqq
D.Geometrical measure of elasticity of demand: If there is a
linear demand curve the point elasticity of demand is measured
by geometrical method i.e. it is the ratio of lower segment of the
demand curve below the point to the upper segment of the
demand curve above the point on the demand curve.
Symbolically,
Ep = Lower segment of the de mand curve below the point
Upper segment of the demand curve above the point
The geometric method can be explained through the
Diagram 3.8 given below:munotes.in
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33
Diagram 3.8
3.11 DEGREES OF ELASTICITY OF DEMAND
Different commodities have d ifferent elasticities of demand.
Some commodities have more elastic demand then others, while
other commodities have relative elastic demand. The elasticity of
demand ranges from zero to infinity (0 -∞). It can be equal to zero,
one, less than one, greater than one and equal to unity.
“The degree of responsiveness to the change in demand in a
market for a commodity is great or small, as the amount demanded
increases much or little for a given fall in price and diminishes much
or little for a given rise in p rice of the commodity”.
The various level or the degree of elasticity of demand is
explained in brief below:
1.Perfectly elastic demand (E p=∞):The demand is said to be
perfectly elastic, if slight change in price leads to infinite change
in the quantity demanded of the commodity. In other words, it is
the level of responses where the consumer is able to buy all the
available commodity at a particular price where the demand is
elastic. The demand curve under this situation is horizontal
straight line parallel to X axis shown in the Diagram 3.9 below.
This type of demand curve is relevant in perfect competition. But
in the real world, this cas e is exceptionally rare and are not of
any practical interest.munotes.in
Page 34
34
Diagram 3.9
2.Perfectly inelastic demand (E p=0 ) : The demand is said to be
perfectly inelastic, if the demand for a commodity does not
change with a change in price of the commodity. In o ther words,
the perfectly inelastic demand of a commodity is opposite to the
perfectly elastic demand. Under the perfectly inelastic demand,
a rise or fall in price of a commodity the quantity demanded for a
commodity remains the same. The elasticity of de mand will be
equal to zero. The demand curve is vertical straight line parallel
to Y-axis shown in the Diagram 3.10.
Diagram 3.10
3.Unitary elastic demand (E p=1 ) : Demand is said to be unitary
elastic when the percentage change in the quantity demanded
for a commodity is equal to the percentage change in its price.
The numerical value of unitary elastic of demand is exactly
equal to one i.e. Marshall calls it as unit elastic. The demand
curve is rectangular hyperbola shown in the Diagram 3.11.munotes.in
Page 35
35
Diagra m3.11
4.Relatively Elastic demand (E p>1 ) : Demand is said to be
relatively elastic, when the percentage change in quantity
demanded of a commodity is greater than the percentage
change in its price. In other words, it refers to a situation in
which a smal l change in price leads to a great change in
quantity demanded. The demand curve under this situation is
flatter as shown in Diagram 3.12. Such demand curve is seen
under monopolistic competition.
Diagram 3.12
5.Relatively Inelastic demand (E p<1 ) : Deman di sr e l a t i v e l y
inelastic when the percentage change in the quantity demanded
of a commodity is less than the percentage change in the price
of the commodity. The demand curve under this situation is
steeper shown in Diagram 3.13. Such demand curve is
obse rved under monopoly market.munotes.in
Page 36
36
Diagram 3.13
Check your Progress :
1)What is the nature elasticity of demand for luxurious good?
2)List down the degrees of Elasticity of Demand.
3.12 INCOME ELASTICITY OF DEMAND
As we have discussed e arlier the factor which determines
elasticity of demand for a commodity. The consumer’s income is
one of the important determinants of demand for a commodity. The
demand for a commodity and consumer’s income is directly related
to each other, unlike price -demand relationship.
Income elasticity of demand shows the degree of
responsiveness of quantity demanded of a commodity to a small
change in the income of a consumer. In other words, the degree of
responsiveness of quantity demanded to a change in income is
measured by dividing the proportionate change in quantity
demanded of a commodity by the proportionate change in the
income of a consumer.
Percentage change in purchases of a commodityIncome Elasticity =Percentage change in incomemunotes.in
Page 37
373.12.1 MEASUREMENT OF INCOME ELASTICITY OF DEMAND
The income elasticity of demand can be calculated by either
point method or arc method.
Point income elasticity of demand is measured by following
formula://yQQEYYQYYQQYYQWhere, Q = Origina lQ u a n t i t yD e m a n d e d .
Y= Original Income.
ΔQ= Change in Quantity Demanded.
ΔY= Change in Income.
Arc income elasticity of demand is measured by following formula:21 2 121 2 1yQQ YYEYY QQ
Income elasticity of demand being zero is a great
significance. It implies that a given increase in the income of a
consumer does not at all lead to any increase in quantity demanded
of a commodity or expenditure on it.
Classification of goods based on income elasticity of
demand: We can broadly classify the various goods on the bas is of
value of income elasticity of demand.
1.Normal Goods: Normal goods are those goods which are
usually purchased by consumer as his income increases. In
other words, normal good means an increase in income causes
an increase in the demand for a commodity . It has a positive
income elasticity of demand. Normal goods are further classified
as:
a.Necessity goods: A good with an income elasticity less
than one and which claims declining proportion of
consumers income as he becomes richer is called a
necessity go od. Necessity goods are those goods where an
increase in income of a consumer leads to less than
proportionate increases in the demand for a commodity. For
example, daily used goods, basic goods etc. the income
elasticity of demand for such goods positive and less then
unity. i.e. E y<1 .munotes.in
Page 38
38b.Luxuries goods: A good having income elasticity more than
one and which therefore bulks larger in consumers budget
as he becomes richer is called a luxury good. Luxuries
goods are those goods where a change in income leads to
direct and more than proportionate change in quantity
demand for a commodity. For example, diamonds,
expensive cars, etc. Thus, income elasticity of demand for
such goods is positive and greater than one i.e. E y>1 .
c.Comfort goods: Comfort goods are those goods where
change in income leads to direct and proportionate change
in quantity demanded. For example, semi -luxury goods and
comfort items. Income elasticity of such goods are positive
and unity. i.e. E y=1 .
2.Inferior goods: Inferior goods are thos eg o o d sa r ew h e r e
consumer buys less of goods as his income increases. Goods
having negative income elasticity are known as inferior goods.
As income of a consumer increases his demand for goods shifts
from inferior to superior. The income elasticity for s uch goods
are0yE.
3.Neutral goods: when a change in income of a consumer brings
no change in the quantity demanded of a commodity. For
example, salt, rice, pulses etc. elasticity for such goods are0yE.
3.13 CROSS ELASTICITY OF DEMAND
Sometimes we find two goods are inter -related to each other
either they are substitute goods or commentary goods. Cross
elasticity of demand measures the degree of responsiveness of
demand for one good in responsive to the chang e in the price of
another good.
cPercentage change in quantity demanded of commodity 'X'E=Percentage change in the price of commod ity 'Y'
Classification of goods based on value of cross elasticity of
demand:
a.Substitution: If the value of elasticity between two goods are
positive the goods are said to be substitute to each other. For
example, Tea and coffee, if the price of tea increases the
demand for coffee increases.
b.Complementary: if the value of elasticity between two goods
are negative the goods are said to be complementary. Formunotes.in
Page 39
39example, car and petrol, if the price of petr ol increases the
demand for car decreases.
c.Unrelated: if the value of elasticity between two goods are zero
then the goods are said to be unrelated to each other. For
example, table and car, if the price of table increases there is no
change in the deman d for car.
3.14 PROMOTIONAL ELASTICITY OF DEMAND
It is also known as ‘Advertisement elasticity’. In modern
times an increase in expenditure on advertisement or promotion
leads to an increase in the demand for a commodity Promotional
elasticity of deman d is the proportional change in quantity demand
due to proportionate change in promotional expenditure. In other
words, percentage change in the quantity of demand for a
commodity divided by the percentage change in promotional
expenditure shows the promot ional elasticity of demand.
APercentage change in quantity demandedEPercentage change in advertisement expenditure
The greater the elasticity of demand, its better for a firm to
spend more on promotional activities. The pro motional elasticity of
demand is usually positive.
Check your Progress :
1)How income of a Consumer related to the demand of the
commodity?
2)If the Consumer income increase. What will be the elasticity of
demand for necessity goods?
3.15 CONCEPTS OF REVENUE
The term revenue refers to the income obtained by a firm or
aseller through the sale of commodity at different prices. The
revenue is classified as:munotes.in
Page 40
401.Total revenue: The total revenue or income earned by a firm or
producer from the sale of the output he produced is called the
total revenue. Thus, the total revenue is the price multiply the
quantity of output.
TR = P×Q
Where,
TR = Total Revenue.
P = Price of a commodity.
Q = Total Output sold.
Thus, Total revenue is the sum of all sales, receipts or
income of a firm in the market.
2.Average revenue: The average re venue refers to the revenue
obtained by the firm by selling the per unit of output of a
commodity. It is obtained by dividing the total revenue by total
unit of output sold in the market.
AR = TR
Q
Or
AR = P
Where, AR= Average revenue.
The average revenue curve shows that the price of the firm’s
product is the same at each level of output. In other words, the
average revenue curve of a firm is al so the demand curve of the
consumer.
3.Marginal revenue: Marginal revenue is the additional revenue
earned by selling an additional unit of the commodity. In other
words, Marginal revenue is the change in total revenue due to
the sale of one additional un it of output. Thus, marginal revenue
is the addition commodity made to the total revenue by selling
one more unit of the commodity. In algebraic terms, marginal
revenue is the net addition to the total revenue by selling n units
of a commodity instead of n –1.
Thus, MR n=T R n-TRn-1
Or
MR = ΔTR
ΔQ
Relationship between price elasticity and total revenue:
Elasticities of demand can be divided into three broad categories:
elastic, inelastic, and unitary. An elastic demand is one in which the
elasticity is greater than one, indicating a high responsiveness to
changes in price. Elasticities that are less than one indicates low
responsiveness to price changes and correspond to inelasticmunotes.in
Page 41
41demand. Unitary elasticities indicate proportional responsiveness of
either demand or supply, as summarized in the following table:
Total
revenueChange in
priceElasticity Reasons
Increase
DecreaseFall
RiseEp>1 Percentage
change in
quantity
demanded is
greater than the
percentage
change in price.
Decrease
IncreaseFall
RiseEp<1 Percentage
change in
quantity
demanded is
smaller than
percentage
change in price.
Unchanged
UnchangedFall
RiseEp=1 Percentage
change in
quantity
demanded is
equal to
percentage
change in price.
Table 3.3
The relationship between the price elasti city and total revenue
shows the following analysis from the above table.
A.When demand is elastic, price and total revenue move in
opposite directions.
B.When demand is inelastic, price and total revenue moves in
same direction.
C.When demand is unitary elasti c, total revenue remains
unchanged with the price changes.
This relationship can be easily understood by the following
diagram: 3.14
Relationship between price elasticity and Average revenue
and Marginal revenue: The relationship between AR, MR and
elast icity of demand is very useful to understand at any level of
output.
This relationship is also very useful to understand the price -
determination under different market conditions. It has beenmunotes.in
Page 42
42discussed that average revenue curve of a firm is the same thin ga s
the demand curve of the consumer for the product of the firm under
market.
This relationship can be explained with the following diagram: 3.14
Diagram 3.14
3.16 MEANING
Demand forecasting means estimation of demand for the
product for a future p eriod. Demand forecasting enables an
organization to take various decisions in business, such as
planning about production process, purchasing of raw materials,
managing funds in the business, and determining the price of the
commodity. A business organiza tion can forecast demand for his
product by making own estimations called guess or by taking the
help of specialized consultants or market research agencies.
3.17 SIGNIFICANCE OF DEMAND FORECASTING
Demand forecasting plays an important function in the
management of various business decision. Forecasting help the
business firm to know what is likely to happened in future and to
reduce the degree of risk and uncertainty in business and to make
various business policy decision and action of the future. Thus ,a
demand forecasting is meant to guide business policy decision.
The significance of demand forecasting are as follows:
1)Fulfils the s ubjective :Demand forecasting implies that every
business unit starts with certain pre -determined objectives.
Deman d forecasting helps in fulfilling these objectives. An
organization estimates the current demand for its products andmunotes.in
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43services in the market and move forward to achieve the set
goals.
For example, an organization has set a target of selling 60, 000
units of its products. In such a case, the organization would
make demand forecasting for its products. If the demand for the
organization’s products is low, the organization would take
remedial actions, so that the set objective can be achieved.
2)Production plan ning: Demand forecasting is important to
forecast the future production plan of business firm. There is a
gestation period between production of goods and services and
demand for it. Demand forecasting help to eliminate those gaps
between demand and supply of goods preventing shortages and
surplus.
3)Distribution and avoidance of wastage of resources
planning: The business firm has to take decision regarding the
distribution of capital, machinery, raw material in the production
process. So that if there is a ny shortage of those resources can
be arranged prior through estimation. Making a right and correct
estimation of using resources reduces the usage of it.
4)Sales distribution policy: Sales of goods and service gives
revenue to the firm’s demand. Forecasting is nothing but
estimating the sales of the product. To formulate realistic sales
targets and to make arrangements for the movement of
production for the movement of product region wise, demand
forecasting is very essential. This can help to formulate an
effective sales policy, and therefore, to increase sales revenue.
5)Price policy: The firm has to make decision regarding the price
of goods and services which is a critical job. The firm has to
make appropriate price policy so that there is no price
fluctuat ion in the future.
6)Reduce business risk: Every business has certain risk.
Demand forecasting help the business firm to make appropriate
business decision to reduce such risk and uncertainty to a
certain extent.
7)Inventory planning: Inventories are goods an dr a wm a t e r i a l s
held by the firm future sale. Demand forecasting helps in
devising appropriate inventory management policies.
Check your Progress :
1)How demand forecasting health business firm in predicating
future demand for his product?
2)List down the factors determining nature of demand forecasting.munotes.in
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443.18 STEPS IN DEMAND FORECASTING
The demand forecasting finds its significance during large -
scale production of goods and services. During such period of time
firms may often face difficu lties in obtaining a fairly accurate
estimation of future demand. Thus, it is essential for a firm to
forecast demand systematically and scientifically to arrive at
desired objective. Therefore, the following steps are to be taken to
facilitate a systemati c demand forecasting:
1.Determining the objective: The very first step in demand
forecasting is to determine its objective of forecasting. The
objective for which the demand forecasting is to be done must
be clearly specified. The objective of forecasting ma yb ed e f i n e d
in terms of; long -term or short -term demand, the whole or only
the segment of a market for a firm’s product, overall demand for
a product or only for a firm’s own product, firm’s overall market
share in the industry, etc. The objective of the demand must be
determined prior in the process of demand forecasting begins
as it will give direction to the whole research.
2.Nature of forecast: After determining the objective of
forecasting the second important step is to identified the nature
of demand forecasting. Its based on the nature of forecasting.
3.Nature of commodity: While forecasting it is important to
understand the nature of the product whether it is consumer
goods or producer goods, perishable goods or durable goods. If
the good is perishable the forecasting is to be done in a short
period of time and for durable goods it may be done in long run.
4.Determinants of demand: Determinants of demand play an
important role in determining the forecasting as different
commodity have different factor det ermination of demand which
depends upon the nature of commodity and nature of
forecasting. The important determinants are price of the
commodity, price of related goods, income of a consumer etc.
5.Identifying the relevant data: Necessary data for the
forec asting are collected, then tabulated, analysed and cross -
checked by the firm. The data are interpreted by applying
various statistical or graphical techniques, and then to draw
necessary deductions there from. The forecaster has to decide
whether to choose primary or secondary data. The primary data
are the first -hand data which has never been collected before.
While the secondary data are the data already available. Often,
data required is not available and hence the data are to be
adjusted, even manipulat ed, if necessary, with a purpose to
build a data consistent with the data required. Then after
collecting the relevant data from different sources and proceed
for the further step.munotes.in
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456.Selecting the method: After collecting the relevant data the
firm choose t he appropriate method of forecasting the demand.
Appropriate method of sales forecasting is selected by the
company considering the relevant information, purpose of
forecasting and the degree of accuracy required. The choice of
method has to be appropriate and logical. If the required data is
not available toward the method, the forecaster may force to
use less reliable method. The forecaster should use a method
which should not be too time consuming and it should be
reliable for long term.
7.Testing accuracy :After making a choice of method the
forecaster needs to test the accuracy of it. There are various
methods choose to test the accuracy. This testing helps to
reduce the margin of error and thereby helps to improve its
validity for the purpose of decision making
8.Evaluation and conclusion: the last and final step are to
evaluate the forecasting and to draw a conclusion from it.
3.19 METHODS OF DEMAND FORECASTING
The main challenge to the forecaster while forecasting the
demand is to select an effective technique or method. Broadly
speaking methods of demand forecasting are classified into
Qualitative methods and Quantitative methods. Which can also be
classified as Survey method and Statistical method. The forecaster
may choose any of the method dependi ng upon the data which is
available. Under these two broad categories, there are other
specific methods which is been choose to analysis the data. These
two methods will be discussed below:
A.Survey method: This method is also called as qualitative
method o f demand forecasting. This method is one of the most
common and direct method of demand forecasting in the short
run. In this method the future purchase plans of the consumers
and their aims are included. An organization conducts these
surveys with consume rs to determine the demand of their
existing products and services and forecast the future demand
of their product accordingly.
The forecaster may undertake the following survey methods:
a)Expert’s opinion: This method is based on the opinion of
expert who predict the demand for a product based on his
experiences and his knowledge in the particular specialised
field. The expert may be from the same organisation or may be
hired from outside. They may be salesman, sales manager,
marketing expert, market consu ltant etc they act as experts who
can assess the demand for the product in different areas,
regions, or cities. This method involves the opinion of three or
four experts. Each expert will be asked about his opinionmunotes.in
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46regarding the demand for the product and the expert through his
personal experience give his opinion for the product and
forecast the demand. This method is very simple to use and it
requires less statistical work. Due to expert’s personal views the
time for forecasting is short and the cost invo lve is also low. On
the other side as its expert’s personal opinion or guess where its
likely to be biased.
b)Delphi method: Delphi method is a group decision -making
technique of forecasting demand. In Delphi method, a group of
experts gives their opinion o n the demand for the products of
individual firm in future based on questions which have been
asked by the firm. These questions are repeatedly asked until a
result is obtained. In addition, each and every expert is provided
information regarding the estim ates made by other experts in
the group, so that he/she can revise his/her estimations with
respect to others’ estimates. In this way, the forecasters cross
check among experts to reach more accurate decision making.
The main advantage of this method is th at it is time and cost
effective as a number of experts are approached in a short time
without spending much time on other resources. However, this
method may lead to appropriate decision making. This method
allows the forecaster to solve the problem to th ee x p e r t sa to n c e
and have instant response. But the success of this method
depends upon the skills, experience, knowledge, and aptitude of
the expert.
c)Consumer survey method: In this method, the consumers are
directly approached to unveil their future pu rchase plans. This
method is the most direct method because forecasting is done
by interviewing all consumers or a selected group of consumers
out of the relevant population through various other methods of
survey. The firm may choose for complete enumerat ion method,
sample survey method and end use method for sample surveys
depending upon the nature of forecasting. The following
methods are described in brief below:
i.Complete enumeration method: Under the Complete
Enumeration Survey, the forecaster undertak es the survey of
the whole population who demand for the commodity. The firm
may go for a door to door survey by making questionnaire to get
the data requires. This method has an advantage of first hand
data, unbiased information, yet it has its share of d isadvantages
also. The major limitation of this method is that it requires lot of
resources, manpower and time period. There may be a chance
where the consumer or the population may give false statement
or may deliberately misguide the investigators due to which
there may be chance of data error. In this method, consumers
may be unwilling to reveal their purchase plans due to personal
privacy or commercial secrecy.munotes.in
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47ii.Sample survey method: This method is also known as test
market. In this method the forecaster selects the samples of
consumer from the relevant population instead of considering
the whole population. If sample is the true representative of
data, there is likely to be no significant difference in the results
obtained by the survey. Apart from that, this method is less
tedious and less costly then the complete enumeration method.
A sample survey technique is a variant of test marketing.
Product testing basically involves employing the product with a
number of users for a set of periods of time. Their reactions to
the product are noted after a period of time and an estimate of
likely demand is made from the result. These are suitable for
new products or for completely modified old products for which
there is no prior data available. It is a more scient ific method of
estimating like demand because it stimulates the national
launch in a very closely defined geo graphical area. Their can be
a sampling error in this method as the size of sample is small
i.e. smaller the size of sample larger the sampling er ror.
iii.End-use method: This method is quite useful for industries
which are mainly producer’s goods and when a product is used
for more than one use. In this method, the sale of the product is
projected on the basis of demand survey of the industries which
are using this product as an intermediate product, that is, the
demand for the final product is the end user demand of the
intermediate product which are used in the production of this
final product is considered. The end use method of demand
estimation of an intermediate product may involve many final
good industries using this product at home and abroad. It helps
us to understand inter -industry’ relations. The major efforts
required by this type of method are not in its operation but in the
collection and presentation of data. This will help the forecaster
to manipulate the future demand. This policy helps the
government to frame many of its policies. Its major limitations
are that it requires every firm to have a plan of production
correctly for the futur ep e r i o d .
d)Market experiments: This method involves collecting
necessary information regarding the current and future demand
for a product in the market. This method carries out the studies
and experiments on consumer behaviour under actual market
conditi ons. In this method, some areas of markets are selected
with similar features, such as income level , population, cultural
and political background, and tastes of consumers. The market
experiments are carried out with the help of changing prices and
expen diture, so that the resultant changes in the demand are
recorded. These results help in forecasting future demand.
i.Actual market experiment: This method is conducted in the
actual market place in several ways. One method is to select
several market or stor es with similar characteristics. Thismunotes.in
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48method is very useful in the process of introducing a product
for which no other data exist.
ii.Simulated market experiment: This method is also called
as consumer clinic or laboratory experiment. Under this
method the f irm make a set of consumers and give them a
sum of money and asked them to shop in a stimulated store.
While shopping the consumer reaction towards the change
in price of a product, packaging, advertisement etc are taken
into consideration.
B.Statistical me thods: This method is also called as quantitative
method. Statistical method is most useful in demand
forecasting. In order to key objectivity, that is, by consideration
of all implications and viewing the problem from an external
point of view, the statis tical methods are used to forecast the
demand of the product to get the accurate solution to the
problems. The following are some statistical methods which are
been used now a day:
I.Trend method: A firm existing for a long time will have its
own data regard ing sales for past years. Such data when
arranged in a chronologically manner will yield what is
referred to as ‘time series. Time series method shows the
past sales with effective demand for a particular product
under normal conditions. Such data can be g iven in a tabular
or graphic form for further analysis. This is the most popular
method among business firms, partly because it is simple
and cheap and partly because time series data often show a
persistent growth trend. Time series has got four types of
components namely, Secular Trend (T), Secular Variation
(S), Cyclical Element (C), and an Irregular or Random
Variation (I). These time elements are expressed by the
equation O = TSCI. Secular trend refers to the long run
changes that occur as a result of general tendency.
Seasonal variations refer to the changes in the short run
weather pattern or the social habits. Cyclical variations refer
to the changes that occur in industry during a depression
and boom period. Random variation refers to the factors
which are generally able such as wars, strikes, natural
calamities such as flood, famine and so on. When a
prediction is made the seasonal, cyclical and random
variations are removed from the observed data. Thus, only
the secular trend is left. This trend is then projected. Trend
projection fits a trend line into a mathematical equation. The
trend can be estimated by using any one of the following
methods:
(a) The Graphical Method: Graphical method is the
simplest technique to determine the trend analysis. Al l
values of output or sale of product for different years aremunotes.in
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49plotted on a graph and a smooth free hand curve is drawn
passing through as many points as possible on the graph.
The direction of this free hand curve is either upward or
downward and shows the possible trend.
(b) The Least Square Method: Under the least square
method of forecasting, a trend line can be fitted to the time
series data with the help of statistical techniques such as
least square method of regression. When the trend in sales
over t ime is given by straight line, the equation of this line is
in the form of: y = a + bx. Where ‘a’ is the intercept and ‘b’
shows the impact of the independent variable. We have
taken two variables i.e. the independent variable x and the
dependent variable y. The line of best fit establishes a kind
of mathematical relationship between the two variables v
and y. This is expressed by the regression у on x.
In order to solve the equation v = a + bx, we have to make
use of the following normal equations:
Σy=na + b ΣX
Σxy =a Σx+bΣx2
II.Regression method: regression methods attempts to
assess the relationship between at least two variables (one
or more independent and one dependent), the purpose is to
predict the value of the dependent variable from the spe cific
value of the independent variable. The foundation of this
prediction generally is historical data. This method starts
from the assumption that a basic relationship exists between
two variables. An interactive statistical analysis computer
package is used to formulate this mathematical relationship.
Check your Progress :
1)List down the steps of demand forecasting.
2)Define survey method of demand forecasting.
3)Define Delphi method of demand forecasting.
3.20SUMMARY
In this unit we have analysed the demand concept and its
various function along with the law of demand. In economics bothmunotes.in
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50demand and supply are the important forces through which market
economy functions. But in this unit, we will focus more on demand
side. The demand function shows the relationship between the
quantity demanded and its various determinants. In this chapter we
will explain the demand function in detail. Demand function is an
arithmetic expression that shows the functional relationship
between the demand for a commodity and the various factors
affecting it. It has also explained he nature of demand curve under
different market situation. We have also discussed the nature of
demand curve under different market conditions with the various
elasticity concept s and its measures in detail. Elasticity of demand
helps us to estimate the level of change in demand with respect to
a change in any of the determinants of demand. The concept of
elasticity of demand helps the firm or manager in decision making
with respe ct to pricing, promotion and production polices. The
elasticity of demand measures the elasticity of four important
factors i.e. price, income, cross and promotional with three
important measures of point, arc and geometric measures of
elasticity. The uni t also deals with the various revenue of the firm in
business and their relationship in detail.
This unit study the demand estimation and its forecasting.
Demand forecasting play a vital role in business planning. Busine ss
enterprises need to plan their activities. Most of the business
decisions of a firm under an organization are made under the
conditions of risk and uncertainty. Demand forecasting is a
systematic process that involves anticipating the demand for the
product and services of an organization in future under a set of
uncontrollable and competitive forces in the economy. Demand
forecasting helps the business firms to take appropriate decision
about the production and the use of factors of production to fulfil the
future demand of the commodity. It had studied the importance or
significance of demand forecasting. Demand forecasting plays an
important function in the management of various business decision.
Forecasting help the business firm to know what is like ly to
happened in future and to reduce the degree of risk and uncertainty
in business and to make various business policy decision and
action of the future. The unit explains the various steps in
forecasting demand. It has also explained the two major meth ods of
demand forecasting in detail.
3.21 QUESTIONS
1.What is demand forecasting? Explain its importance.
2.Discuss the steps to be taken to estimate demand forecasting.
3.Explain the survey methods of demand forecasting.munotes.in
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514.Examine the statistica l methods of demand forecasting.
5.Explain the law of demand and the factors with determines the
demand.
6.Explain the nature of demand curve under different markets.
7.What is demand function? Explain in detail.
8.What is elasticity? Explain price el asticity of demand in detail.
9.Explain the measurements of price elasticity of demand.
10.Discuss the different degrees of elasticity of demand.
11.What are the factors affecting price elasticity of demand?
12.Write a note on:
a)Income elasticity of dem and.
b)Cross elasticity of demand.
c)Promotional elasticity of demand.
13.Explain the concepts of revenue in detail.
munotes.in
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52MODULE -IV
4
PERFECT COMPETITION
UnitStructure :
4.0 Objectives
4.1 Meaning
4.2 Features of perfect competition
4.3 Profit Maximisation
4.4 Perfect Competition in the Short Run
4.5 Long run equilibrium of a firm
4.6 Equilibrium of a firm and i ndustry under perfect competition
4.7 Summary
4.8 Questions
4.0 OBJECTIVES
To understand the meaning and features of perfectly
competitive market.
To study the concept of profit maximisation of firm under perfect
competition.
To understand the short ru na n dl o n gr u ne q u i l i b r i u mo faf i r m .
To understand the equilibrium of a firm and industry under
perfect competition .
4.1 MEANING
The theory of perfect competition has origin ated in the late -
19th century. The first laborious definition of perfect competi tion
and resultant some of its main results was given by Léon Walras.
Then later in the 1950s, the theory was further redefined by
Kenneth Arrow and Gérard Debreu. But in reality, markets are
never perfect.
A perfectly competitive market is a hypothetica li nn a t u r e . In
this market p roducers are large in number; however, they may face
many competitor firms selling highly similar types of goods, in which
case they often act as price takers. Agricultural markets are
commonly used as an example.munotes.in
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53A perfectly c ompetitive firm is also known as a price taker
because the pressure of competing firms in the market forces other
firms to accept the price prevailing in the market. If a firm in a
perfectly competitive market try to raise the price of its product in
the m arket it will lose all of its share s in the market . The market
price in the perfect competition is determined by the market supply
and market demand in the entire market and not by the individual
firm or seller in the market .Further in this chapter we wi ll try to
discuss the price determination and equilibrium of the firm and
industry under perfect competition.
4.2 FEATURES OF PERFECT COMPETITION
Perfect competition can be generally understood by its
following important features:
1.Large number of buye rs and seller s:The very first important
feature of perfect competition is its number of participants i.e.
number of buyers and sellers. Both buyers and sellers are large
in number under perfect competition . The existence of these
large number of buyers an ds e l l e r sm a k e sn oi n f l u e n c e over
price of the product. Therefore, the individual firm under perfect
competition is a price taker because he has no influence over
the price. Whatever price the market demand and market supply
collectively decide every firm is expected to follow the same.
2.Homogeneous or Similar products: The second important
feature of perfect competition is the commodity which is being
sold in the market. It means that the product or commodity
which is sold in perfect competition is similar or identical in
nature . As the product are identical or similar in nature the firm
has no control over the price of the product because products
are perfect substitute for one another. No firm can try to charge
different price to consumer then the market price due to
homogeneous factor of product.
3.Free entry and exit of firm: There are no restriction to the
entry and exit of firm in the market. The condition of free entry
and free exit of a firm applies only in the long run, in short run
firms can neithe r change the size of their plant s, nor new firms
can enter or old firm can leave the market. If the existing old firm
earns super normal profit in the short run will attract the new
firm to enter in the market in the long run.
4.Complete market information :It is assumed that there is a
perfect knowledge about the market situation to both buyers and
seller in the perfect competition. A perfect knowledge or
complete information about the market demand and market
supply, price etc. This allows the firms and b uyer to take
appropriate decision to influence the market demand and supply
collectively.munotes.in
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545.Prefect mobility of factors of production: Under perfect
competition the factors of production are assumed to be freely
mobile. Factors of production such as labour and capital are
assumed to be mobile. The mobility of factors helps the firm to
adjust the market demand with the change in market supply.
6.No transportation cost: It is assumed that there is no
transportation cost under perfect competition. It applies whe n
the production area and sales market take place in a small
geographical area or in the same area. For example, agriculture
products are sold in the same village or town which requires no
transportation cost.
Check your Progress :
1)Why uniform price e xist in perfect competition?
2)Why we don’t consider transportation cost?
4.3 PROFIT MAXIMISATION
Profit is the main objective of any firm into business. Each
and every firm tries to makes maximum possible profit into the
business. Firm earn s profit when Total revenue which has earned
subtracted from the Total cost which he has bare for the production.
To state
Where
Profit, TR = Total Revenue, TC = Total Cost.
Total revenue (TR) is the total revenue firm earned after the sale of
his product .To state
TR = P × Q
Where ,TR is Total Revenue, P = Price per unit, Q = Quantity per
unit sold.
Total Cost (TC) is the total cost which a firm spend to produce the
product .W eo b t a i ni tb ym u l t i p l y i n gt h e quantity of output produce
by the average cost.
TC = Q ×AC
Average revenue (AR) is the revenue generated by selling per unit
of output.
AR = TR
Qmunotes.in
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55Where AR is the Average Revenue.
Hence if, P × Q = TR=A R
Q
Therefo re, we can say that,
P=A R
Therefore, we say that the price under perfect competition is
equal to the average revenue which a firm earns in a market.
Af i r mi na perfectly competitive market tries to maximize his
profits. In the short -run, it is possi ble for a firm to earn profits which
can be positive, negative, or zero. Economic profits which the firm
earns will be zero in the long -run.
In the short -run, if a firm earns negative economic profit, it is
said that he should continue to operate his busi ness if its price
exceeds its average variable cost and he should shut down if its
price is below its average variable cost.
The marginal revenue (MR) is the change in total revenue
from an additional unit of output sold in the market for which the
firm b ares Marginal cost .
MR = ΔTR
ΔQ
Marginal Cost (MC) is the additional cost which a firm spends to
produce the additional unit of output.
MC = Δ TC
ΔQ
In order to maximize theprofits in a perfectly competitive
market, thefirms set the price where the marginal revenue equal to
marginal cost (MR=MC). The MRcurve is the slope of the revenue
curve, which is also equal to the demand curve (D D),price (P) and
the Marginal and Average Revenue curve .Therefore, In the short -
term, it is possible for af i r mt oe a r neconomic profits to be positive,
zero, or negative. When price is greater than average total cost, the
firm is making a profit. When price is less than average total cost,
the firm is making a loss in the market .munotes.in
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56
Diagram 4.1
Perfect Competition in t he Short Run: In the short run, it is
possible for an individual firm to make an economic profit. This
state is shown in th ea b o v e Diagram 9.1, as the price or average
revenue, denoted by P, is above the average cost denoted by AR.
Inthe long -run, if fir mstry to earning positive economic profits,
more and firms will enter into perfectly competitive market are,
which will shift the supply curve to the right of the original place .A s
the supply curve shifts to the right, the equilibrium price of the firm
will go down. As the price goes down, theeconomic profits will
decrease until they become zero.
When theprice is less than theaverage total cost of the production ,
at that time the firms are making a loss. Inthe long -run, if firms in a
perfectly compet itive market are earning negative economic profits,
then more firms will leave the market andwhich in turn will shift the
supply curve left of the diagram . As the supply curve shifts to the
left, the price wil l rise . As the price rises ,theeconomic profi ts will
increase until they become zero.
Inthe long -run, companies that are engaged in a perfectly
competitive market will earn zero economic profits. The long -run
equilibrium point for a perfectly competitive market occurs where
the demand curve ( price)( P)intersects the marginal cost (MC)
curve a tthe minimum point of the average cost (AC) curve.munotes.in
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57
Diagram 4.2
Perfect Competition in the Long Run: In the long -run, economic
profit cannot be constant .T h e entry of new firms in the market will
cause the de mand curve of each individual firm to shift the demand
curve downward, bringing down the price, the average revenue
(AR) and marginal revenue curve (MR) .I nt h el o n g -run, the firm will
make zero economic profit. Its horizontal demand curve will touch
its average total cost curve at its lowest point (E).
The firm is at equilibrium at the point (E) where Marginal revenue
(MR) is tangent to Marginal cost (MC) .
4.4 SHORT -RUN EQUILIBRIUM OF A FIRM UNDER
PERFECT COMPETITION
The short run is a period of time within which the firms can
change their level of output only by increasing or decreasing the
amounts of variable factors such as labour and raw material, while
fixed factors like capital equipment, machinery, etc. remains
unchanged.
In other words, short run is the conceptual time period where
at least one factor of production is fixed in amount while other
factors are variable.munotes.in
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58A firm in short run is in equilibrium at a point where Marginal
Revenue (MR) is equal Marginal Cost (MC) i.e. MR=MC and where
MCis increasing at the point or MC is cutting MR from below.
The firm under perfect competition operates under the U -
shaped cost curve. Since marginal revenue is the same as price or
average revenue under perfect competition, the firm will equalise
margina l cost with price to attain the equilibrium level of output.
A firm under perfect competition in short run being in
equilibrium does not necessarily earn profit. The firm determines
the equilibrium level of output and price and tries to earn excess
profit, normal profit or may even i ncur loss. The Diagram 9.3 which
is given below will explain the firm’s equilibrium situation in the
short run.
Diagram 4.3
In the above fig Level of output is determined on the X axis
and price on the Y axis.
The firm may face excess profit, normal profit or even loss
can be understood by the given fig above.
1.Excess Profit: OP is the price at which the firm sell its OQ level
of output. Where, E is the is the equilibrium point wheremunotes.in
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59Marginal Cost is equal to Marginal Re venue (MR=MC) and
where MC is increasing which fulfils the condition.
Now to determine the firm’s level of profit we calculate:
Profit = TR -TC
Where, TR = P ×Q
Where, TR is the total revenue which a firm earns by selling the
output, P, is the price per unit sold and Q is the quantity sold.
So, in the above fig,
TR = OP × OQ = OQEP.
TC = Q × Revenue/ Cost.
Where, TC is the total cost
TC = OQ × OQRS
Therefore,
Profit = TR –TC
=O Q E P –OQRS
=SREP
Thus, the firm in the short run wh en the price is OP is at the
equilibrium and earns SREP amount of profit which is the excess
profit which is also called as super normal profit.
2.Normal Profit: the perfect competitive firm may also earn
normal profit in the short run if he fails to earn the super normal
profit. In the above fig 9.3 if the firm is in equilibrium at the point
E1 where OP1 is the price and OQ1 is the level of output. The
firm is at the position where he earns normal profit.
Profit = TR –TC
Where, TR = P ×Q
=OP1 ×OQ1
=O Q 1 E 1 P 1
TC = Q × Revenue/ Cost
=O Q 1×E 1 P 1
=OQ1E1P1
Therefore,
Profit = TR –TC
=O Q 1 E 1 P 1 -OQ1E1P1
=N o r m a lP r o f i t .
Thus, the firm at price OP1 earns Normal profit.
Normal profit is the profi t which a firm must get to survive
into the business where he can produce the same level of output in
future with the amount of revenue he earns. It is a situation of no
profit no loss. If the firm unable to make a normal profit he may go
into loss.
3.Loss or Sub -normal profit: when a firm fails to earn even
normal profit and still continue to operate his business by
incurring into loss. Such situation can be explained as flow:munotes.in
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60The firm is equilibrium at the point E2 where OP2 is the market
price and OQ2 is the level of output.
Profit = TR –TC
Where, TR = P ×Q
=O P 2×O Q 2
=O Q 2 E 2 P 2
TC = Q × Revenue/ Cost
=O Q 2× US
=OQ2US
Loss = P2E2US
4.Shut down point: Whenthe firm not even able to earn variable
cost he better tries to shut down his business or stops operating
for that particular time.
Diagram 4.4
In the above Diagram 9.4 when the price is OP, the firm
produces the equilibrium level of output which is O Q at that price
and at that volume of output the firm total revenue (TR) is OQRP
and his Total Variable Cost (TVC) is OQSN so the loss which firm
gets in terms of variable cost is PRSN. His total loss is PRUT of
which PRSN is variable cost and NSUT is the fixed cost. At this
time, it is better for a firm to either shut down his business or to wait
for a time when the price goes up for his commodity where at least
he can cover up his Total Variable Cost. It is because that variable
cost enables the firm to o perate in his business.munotes.in
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61Check your Progress :
1)What do you mean by shut down point of firm?
2)What is normal profit?
3)What is super normal profit?
4)What is subnormal profit?
4.5 LONG RUN EQUILIBRIUM OF A FIRM
The long run is a peri od of time which is sufficiently long to
allow the firms to make changes in all factors of production.
Therefore, it is said that in the long run, all factors of production are
variable and no factors are fixed. So in the long run the firms, can
increase o r decrease their output by changing their capital
equipment; they may expand or contract their old plants or replace
the old lower -capacity plants by the new higher -capacity plants or
add new plants in the business or the firms can contract their output
level by reducing their capital equip-ment; they may allow a part of
the existing capital equipment to wear out without replacement or
sell out a part of the capital equipment
Besides, in the long run, new firms can enter the industry to
compete the existin gf i r m s .M o r e o v e r ,t h ef i r m sc a nl e a v et h e
industry in the long run. The long -run equilibrium then refers to the
situation when free and full adjustment in the capital equip-ment as
well as in the number of firms has been allowed to take place. It is
there fore long -run average and marginal cost curve which are
relevant for deciding about equilibrium output in the long run.
Moreover, in the long run, it is the average total cost which is of
determining importance, since all costs are variable and none fixed.
As explained above, a firm is in equilibrium under perfect
competition when marginal cost is equal to price i.e. MC = P .B u t
for the firm to be in long -run equilibrium, besides marginal cost
being equal to price, the price must also be equal to average c ost
(P = MC) .
For, if the price is greater or less than the average cost,
there will be tendency for the firms to enter or leave the industry. If
the price is greater than the average cost, the firms will try to earn
more than normal profits. These supern ormal profits will attract st h e
new firms to enter into the industry.munotes.in
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62With the entry of new firms in the industry, the price of the
product will go down as a result of the increase in supply of output
and also the cost will go up as a result of more intens ive
competition for factors of production will be generated .T h ef i r m s
will continue entering the industry until the price is equal to average
cost so that all firms are earning only normal profits.
These can be explained with the help of the following
Diagram 9.5 given below:
Diagram 4.5
Diagram 1.5represents the equilibrium condition of firm
under perfect competition. The firm in the long -run equilibrium is at
a price OP and quantity of output is OQ where the equilibrium point
is E. at the equilibr ium point MR = MC. As said the firm earns
normal profit in the long run so,
Profit = TR -TC
=O Q E P –OQEP
Therefore, the firm earns normal profit in the long run where,
P= AR= MR= AC= MC.munotes.in
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634.6 EQUILIBRIUM OF A FIRM AND INDUSTRY UNDER
PERFECT CO MPETITION
As we have already studied the equilibrium conditions of
both firm and industry. A firm is in equilibrium when it has no
tendency to change its level of output. It needs neither expansion
nor contraction. It wants to earn maximum profits in by e quating its
marginal cost with its marginal revenue, i.e. MC = MR. An industry
is in equilibrium only in the long run. The following Diagram 9.6 will
explain the condition of the equilibrium of a firm and industry.
The MC curve must equal the MR curve (MC=MR) .T h i si s
the first order and necessary condition. But this is not a sufficient
condition which may be fulfilled yet that the firm may not be in
equilibrium. The second order condition says that under perfect
competition, The MC curve must cut the MR c urve from below and
after the point of equilibrium it must be above the MR. the MR curve
of a firm coincides with the AR curve. The MR curve is horizontal to
the X -axis. Therefore, the firm is in equilibrium when MC=MR=AR
(Price).
Diagram 4.6
InDiag ram 9.6 (A), the MC curve cuts the MR curve first at
point A. It satisfies the condition of MC = MR, but it is not a point of
maximum profits because after point A, the MC curve is below the
MR curve. It does not pay the firm to produce the minimum output
OM when it can earn larger profits by producing beyond OM.
Point В is of maximum profits where both the conditions are
satisfied. Between points A and B., it pays the firm to expand its
output because it’s MR > MC. It will, however, stop further
productio n when it reaches the OM1 level of output where the firm
satisfies both the conditions of equilibrium.
If it has any plans to produce more than OM1 it will be
incurring losses, for its marginal cost exceeds its marginal revenuemunotes.in
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64beyond the equilibrium poin t B. The same conclusions hold good in
the case of a straight -line MC curve as shown in Diagram 9.6. (B)
4.7SUMMARY
In this unit we have discussed the perfect competition
market in detail. The theory of perfect competition has originated in
the late -19th century. The first laborious definition of perfect
competition and resultant some of its main results was given by
Léon Walras. Then later in the 1950s, the theory was further
redefined by Kenneth Arrow and Gérard Debreu. But in reality,
markets are neve r perfect. A perfectly competitive firm is also
known as a price taker because the pressure of competing firms in
the market forces other firms to accept the price prevailing in the
market. If a firm in a perfectly competitive market try to raise the
price of its product in the market it will lose all of its shares in the
market. It has also discussed the features of perfect competition
market in detail. The current unit also study the equilibrium of the
firm under short run and long run market conditions.
4.8QUESTIONS
1.What is perfect competition? Explain the features of it in detail.
2. Explain how a firm gets profit maximisation under perfect
competition.
3. Explain the short run equilibrium of the firm under perfect
competition.
4.Discuss the lo ng run equilibrium of the firm under perfect
competition.
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655
MONOPOLY
UnitStructure :
5.0 Objectives
5.1 Meaning of monopoly
5.2 Features of monopoly
5.3 Sources of monopoly power
5.4 Equilibrium of a monopoly firm
5.5 Summary
5.6 Questions
5.0 OBJECTIVES
To understand the meaning and features of monopoly market.
To study the sources of monopoly power.
To understand the equilibrium of a firm under monopoly market.
5.1 MEANING
The word monopoly has been derived from the combinat ion
of two words i.e., ‘Mono’ and ‘Poly’. Mono refers to a single and
poly to control. Monopoly market is said to exist when one firm or a
single firm is a sole producer or seller of a product in a market
which has no close substitutes.
Prof. Bober right ly remarks, “The privilege of being the only
seller of a product does not by itself make one a monopolist in the
sense of possessing the power to set the price. As the one seller,
he may be a king without crown”
According to Koutsoyiannis “Monopoly is a m arket situation
in which there is a single seller. There are no close substitutes of
the commodity it produces, there are barriers to entry”. -
A seller in a monopoly market is known as monopolist. A
monopolist is a price maker not a price taker in the ma rket where
he is the only or a sole seller in the market, where he has control
over it. A monopolist can control both the price as well as the
supply of a commodity to earn profit. But it is said that if a firm is a
rational monopolist, he will control onl yo n ea tat i m e .munotes.in
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665.2 FEATURES OF MONOPOLY
The following are some features of monopoly market:
1.Single Seller and Large Number of Buyers: As said above
monopoly market is run by a single seller known as monopolist.
The monopolist’s firm is the only firm in the market; it is an
industry as well. But the number of buyers is assumed to be
large.
2.No Close Substitutes: Another important feature of monopoly
market is that there shall not be any close substitutes for the
product sold by the monopolist in the mar ket. The cross
elasticity of demand between the product of the monopolist and
others must be negligible or zero.
3.Difficulty of Entry of New Firms: There are either natural or
artificial restrictions on the entry of firms into the monopoly
market.
4.Price Ma ker: Under the monopoly market, the monopolist has
the full control over the supply of the commodity. But due to
large number of buyers, demand of any one buyer constitutes
an infinitely small part of the total demand. Therefore, buyers
have to pay the fix ed amount of price fixed by the monopolist.
5.No distinction between the firm and industry: Under
monopoly market firm being the single seller is the firm as well
as industry. So there is no need to understand the firm and
industry separately.
5.3 SOURCES O F MONOPOLY POWER
The monopoly has numerous factors which gives monopoly
power to the monopolist.
1.Natural monopoly power :Some monopolist gets monopoly
power naturally by the product they produce which is naturally
available to them. A natural monopoly is at y p eo fm o n o p o l yt h a t
exists due to the high start -up costs of conducting a business in a
specific industry. A company with a natural monopoly might be the
only provider or a product or service in an industry or geographic
location in the whole market w hich gives him the monopoly power
naturally. Natural monopolies are allowed when a single company
can supply a product or service at a lower cost than any potential
competitor in the market.
2.Product differentiation: The product which is being sold in the
monopoly market is differentiated product which has no close
substitute in the market. In a perfectly competitive market, every
product is perfectly homogeneous and a perfect substitute for any
other product in the market .W i t ham o n o p o l y ,t h e r ei sg r e a tt omunotes.in
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67absolute product differentiation in the sense that there is no
available substitute for a monopolized good. The monopolist is the
sole supplier of the commodity in the market.
3.Legal protection: Legal is an artificial power which a firm has
to protect th is product from various market competition and make a
product unique or different. Legal protection is in the form of copy
rights, patent rights, trade marks etc. which gives the firm the
monopoly power and make his product different from the other
product in the market.
4.Barriers to Entry: Barriers to entry are factors and
circumstances that prevent entry into market by would -be
competitors and limit new companies from operating and expanding
within the market. Monopolies have relatively high barriers to e ntry
due to its natural and artificial barriers. The barriers must be strong
enough to prevent or discourage any potential competitor from
entering into the market.
5.Control over the resources: As the firm is the only seller in the
market, he has sole cont rol over the resources which is use for
production of the product. The source of control comes either from
the natural or legal power.
5.4 EQUILIBRIUM OF A MONOPOLY FIRM
The Equilibrium condition of a firm under Monopoly is the
same as those under perfe ct competition. Where the marginal cost
(MC) is equal to the marginal revenue (MR) and the MC curve cuts
the MR curve from below. We will understand Equilibrium of
Monopolies in short run and in long run in detail.
Short run equilibrium condition: There a re two possibilities for a
firm’s Equilibrium in Monopoly. These are:
The firm earns normal profits or excess profit –If the total
cost < the total revenue
It incurs losses –If the total cost > the total revenue
Normal Profits or Excess Profit: At Exc ess profit the firm is in
equilibrium at the point E where the Marginal Cost is equal to
Marginal Revenue (MR = MC). At this equilibrium point OP is the
Price and OQ is the level of Output. Firms profit is determined
when,munotes.in
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68
Diagram 4A.1
Profit = TR –TC
Where, TR = P ×Q
=OP × OQ
=O Q R P
TC = Q × AC
=O Q×Q T
=O Q T S
Therefore, Profit = OQRP –OQTS
=S T P R
Thus, the firm earns the excess profit. TR > TC
Loss condition: A firm under monopoly may also face a problem
of getting loss. As in perfect competition even in monopoly the cost
of the firm is divided into fixed cost and variable cost. It is essential
for a firm to receive at least the variable cost t o function in the
market. The loss condition of a monopoly firm can be explained
below with the help of the fig 1A.2.munotes.in
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69
Diagram 4A.2
Profit = TR –TC
Where, TR = P × Q
=O P×O Q
=O Q R P
TC = Q × AC
=O Q× VU
=O Q VU
Therefore, Loss =O Q R P –OQVU
=PRVU
Thus, the firm earns the excess profit. TR Long run equilibrium condition: In the long -run, a monopolist can
contrast all the input s. Therefore, to determine the equilibrium of
the firm, we need only two cost curves –the AC and the MC.
Further, since the monopolist exits the market if he is operating at a
loss, the demand curve must be tangent to the AC curve or lie to
the right and intersect.
A monopolist usually earns excess profit in the long run. This
can be understood by the following fig 1A.3.munotes.in
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70
Diagram 4A.3
Profit = TR –TC
Where, TR = P × Q
=O P×O Q
=O Q TP
TC = Q × AC
=O Q×Q S
=O Q S N
Therefore, Profit = OQ TP–OQS N
=NSTP
Thus, the firm earns the excess profit. TR > TC in the long run.
Check your Progress :
1)Define Monopoly.
2)List out the sources of monopoly power.
3)List out the important features of monopoly market.munotes.in
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715.5SUMMARY
This unit studies the monopoly market in detail. The word
monopoly has been derived from the combination of two words i.e.,
‘Mono’ and ‘Poly’. Mono refers to a single and poly to control.
Monopoly market is said to exist when one firm or a single firm is a
sole producer or seller of a product in a market which has no close
substitutes. The unit has also discussed the features and sources
of monopoly. The unit has also discussed the equilibrium of
monopoly firm during short run and long run.
5.6QUESTIONS
1.What is monopoly? Explain the features of monopoly in detail.
2. Define monopoly. Discuss the various sources of monopoly
power.
3.Explain the short run and klong run equilibrium of a monopoly
firm in detail.
munotes.in
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72MODULE -V
6
MONOPOLISTIC COMPETITION
Unit Structure :
6.0 Objectives
6.1 Features of monopolistic competition
6.2 Equilibrium of a firm under monopolistic competition in the
short run and in the long run
6.3 Production and selling cost
6.4 Role of adv ertising (real life examples)
6.5 Excess capacity and inefficiency
6.6 Summary
6.7 Questions
6.0 OBJECTIVES
•To understand the characteristics features of monopolistic
competition and study determination of price and output in the
short run and in the lon gr u n
•To study the differences between perfect competition and
monopolistic competition
•To understand the difference between selling and production
cost and also to understand the importance of selling cost and
its effects
•To understand how excess capacity is created under
monopolistic competition
•To study the role of advertising along with advantages and
disadvantages with real life examples
6.1FEATURES OF MONOPOLISTIC COMPETITION
Perfectly competitive market and monopoly market are
extreme and therefo re not easy to find in real world.
In the real world the market that we find either have many
sellers selling variety of products (such as toothpaste, textile or
cloth market) called monopolistic competition. Or few sellers having
dominant position in the market (such as airlines, mineral water)
called oligopoly market.munotes.in
Page 73
73Monopolistically competitive market is the market which has
some characteristics of perfect competition and some of monopoly.
Even though there are many sellers under monopolistic
competiti on, each seller has its monopoly but still there is a
competition due to product differentiation. Prof. Edward Chamberlin
introduced the concept of monopolistic competition in his book
Theory of Monopolistic Competition.
Features of monopolistic competiti on
•Fairly large number of sellers -In monopolistic competition
there are many sellers. Therefore an individual seller cannot
influence the market. Every seller to a certain extent follow an
independent policy in price and output.
•Fairly large number of bu yers-There are fairly large number
of buyers in a monopolistically competitive market.
•Close substitute products -Under monopolistic competition
sellers sold products which are close substitutes of each other.
For eg. Soaps, pens etc.
•Free entry and exit -There are no restrictions on entry and exit
of the firm under monopolistic competition. If existing firms are
making supernormal profit, new firms can enter in to the market
but they have to enter with a close substitute product. Similarly
firms who are making loss can leave the market. Therefore in
the long run firm who remains in the market will make only
normal profit.
•Selling cost -As close substitute products are available in
monopolistic competition, firms have to spend money for
increasing sale of their product in the market. This cost is called
as selling cost. It includes all expenditures of the firm which can
increase their sale. It is in the form of T.V, newspaper
advertisement, hoardings, exhibitions, distribution of free
samples, discounts off ered on products etc.
•Product differentiation -As goods are close substitutes ofeach
other, it is necessary to have an independent identity of each
product. Variety of factors on which goods can be differentiated
are brand name, design, size, color, packi ng, taste,
advertisement policy, after sales services etc. Due to product
differentiation, firm can have some degree of monopoly.
•Nature of demand curve -The demand curve of a
monopolistically competitive firm is more elastic. ie demand
curve is flatter th an it is under monopoly. This is because of the
availability of close substitute products, where an increase in
price of one commodity reduces its sale by a greater amount.
Following diagram explains the shape of demand curve under
monopolistic competition .munotes.in
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74
Diagram 5.1
•Concept of group -Prof. E. Chamberlin introduced the concept
of group under monopolistic competition. Group includes those
products which are close substitutes in economic and technical
sense. The group will be in equilibrium in the long run when all
firms in the group make normal profit.
Product differentiation
Product differentiation is one of the characteristics of
monopolistic competition. Products are close substitutes of each
other due to small differences in them. In case of produc ts like
soaps, garments, tooth paste etc. variety of products are available
but each product is different from another due to following factors.
•Brand name -Brand name develops loyalty of public towards
the product. Firms name itself is the name of its pr oduct.
Raymond cloth, LG TV, Colgate toothpastes are some of the
examples of branded products. Brand name helps to
differentiate between the products.
•Design -On the basis of design products can be differentiated.
Fridge, cars, furniture are some of the products which are
purchased on the basis of design.
•Size-Firm produces their product in different sizes so that
consumers can consume their most preferred size. Various
sizes of product include economy size, family size, extra -large
etc.
•Color -Customers would like to purchase various products on
the basis of their color. Products like fridge, cupboard, tooth
brush etc. are consumed on the basis of their color.
•Taste and perfume -Products like soaps, toothpaste, face
powder, shampoo etc. are purchased on the basis of their taste
and perfume.munotes.in
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75•Salesmanship -People prefer products of a particular company
because of the positive attitude of the salesman, their good
behavior, their cooperation etc.
•After sales services -Customers consider after sales services
while consuming a product. This is because products like TV,
fridge, water purifier have a warranty period during which
company provide free services to their customers. Thus the
quality of after sales services is very important.
Due to above factors consu mers have some loyalty to their
products. Loyalty towards product gives some degree of monopoly
to the firm. Product differentiation allows firms to charge different
prices for their products. Under monopolistic competition it is
necessary for the firm to maintain monopoly power over loyal
customers.
6.2 EQUILIBRIUM OF A FIRM UNDER MONOPOLISTIC
COMPETITION IN THE SHORT RUN AND IN THE
LONG RUN
Short run equilibrium of a firm under monopolistic
competition:
Monopolistically competitive firm can operate with
supernormal profit, normal profit or loss in the short run. Following
diagrams explains all the three cases.
•Excess profit
Given the demand curve and cost curves of a firm, firm
would produce profit maximizing level of output at that point where
MR=MC. T his is the equilibrium level of output for the firm.
Diagram 5.2munotes.in
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76On the X axis we measure output and on the Y axis we
measure cost and revenue. AR and MR are the average and
marginal revenue curves which are more elastic or flatter. SAC and
SMC are the short run average and marginal cost curves. Firms
equilibrium point is E and equilibrium level of output is OQ. Thus
the price determined is OP or QM.
In the above diagram with price OP and output OQ, TR= OQMP,
TC=OQ ER. As TR>TC, Excess profit = R EMP (OQ MP-OQER)
•Normal profit
Condition for normal profit is very rare. Due to change in
demand and cost conditions, sometimes it is possible for the firm to
just cover its cost of production ie the case of normal profit.
Diagram 5.3
With given revenue and cost curves firm is in equilibrium at
point E1, with the intersection of MR and MC curves. Output= OQ1,
Price= OP1, TR= OQ 1R1P1
TC= OQ 1R1P1. As TR=TC, the firm will make normal profit.
•Loss
Due to demand and cost conditions it is also possible that
firm m ay operate with loss. With the help of following diagram we
can explain the case of loss.munotes.in
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77
Diagram 5.4
With given revenue and cost curves, firm is in equilibrium at
point at point E2, where MR and MC curves intersects.
Equilibrium output= OQ2 an d equilibrium price = OP2. TR=
OQ 2L2P2,TC=OQ 2N2M2. As TC>TR, firm will make loss. Loss=
P2L2N2M2
In the short run when the firm incurs loss, it has to decide
whether to continue with the business or not. As long as the firm is
able to cover its total var iable cost, it will continue with the business
and when TRLong run equilibrium of a firm under monopolistic
competition:
In the long run it is possible for the firm to make all
necessary changes in its fixed factors of production. As all costs
are variable, firm cannot continue to operate with loss. As there is
free ent ryand free exit, due to supernormal profits earned by the
existing firms, more firms will enter the market and firms which
cannot cover the cost of p roduction will leave the market. More
firms who are entering the market reduces the share of existing
firms and therefore in the long run all firms will make only normal
profit. The case of normal profit can be discussed with the help of
following diagram.munotes.in
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78
Diagram 2.5
With given revenue and cost curves, equilibrium point is E
where MR and MC curves intersects. Equilibrium output= OQ,
price= OP TR= OQRP TC= OQRP. As TR=TC, there is a normal
profit.
6.3 PRODUCTION COST AND SELLING COST
Produc tion cost includes all those expenditures incurred by
the firm to produce a commodity and to reach to shops. It includes
rent on land, wages and salaries paid to workers, interest on
capital. Depreciation charges, taxes etc. The objective of
production cos ti st op r o d u c eac o m m o d i t y .
On the other hand the purpose of selling cost is to increase
the sale of its product in the market. Due to the availability of
substitutes, selling cost is very important for the firm under
monopolistic competition. Through se lling cost firms try to spread
the message regarding how their product is better than the other
products available in the market.
Selling costs are incurred in various forms like T.V
advertisement, newspaper advertisement, pamphlets, hoardings,
distribut ion of free samples, gifts, discounts offered on products,
exhibitions ,after sales services etc.
The concept of production and selling cost can be explained
with the help of following diagram.munotes.in
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79
Diagram 5.6
As shown in the diagram, the difference be tween Average
Cost (AC) and Average Production Cost (APC) is the Average
Selling Cost (ASC).
Selling cost:
Selling cost is one of the important features of monopolistic
competition. Under perfect competition, as there are homogeneous
goods there is no nee d for selling cost. Similarly under monopoly
due to the absence of substitute products, selling cost is not
required. But in case of monopolistic competition as close
substitute products are available, firm has to incur selling cost.
Thus the cost incurred by the firm to promote their product in the
market or to increase the demand for the product in the market is
called the selling cost. Various forms of incurring selling cost are as
follows -
•Advertising -this is the main form of selling cost. Through
advertisement the firm is trying to show how their product is
superior to other products that are available in the market.
Advertisement can be through T.V, radio, newspaper,
hoardings, distribution of pamphlets etc.
•Exhibitions -exhibitions can be held at lo cal, state, national and
an international level. The purpose of exhibition is to increase
the sale of the product.
•Window dressing -various products like garments, electronic
items, and other consumer durables are displayed to the
consumers to provide som e idea about the product and also to
attract the consumers.
•Free samples -in case of goods like soaps, tea, biscuits, oil,
hand wash etc. Companies distribute free samples to attract the
large number of customers.munotes.in
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80•Gifts -various gifts are offered by the c ompanies on purchase of
a specific amount.
•Discounts -another way of attracting large number of
customers is to offer them large discounts. Once the market for
the product is established, the discount may be withdrawn.
•After sales services -good after sale s services play an
important role in gaining goodwill of the customers. Along with
better after sales services, warranty period, relation with
customers etc. are also important to have greater sale of their
product in the market.
Effects of selling cost
Selling cost affects the consumers demand. It makes people
aware of the existing commodity and also inform them how their
product is better than substitutes available in the market. Effect of
selling cost on demand can be explained with the help of followi ng
diagram s.
Diagram 5.7
In the above diagrams X axis measures quantity demanded
and Y axis measures price. In the first diagram DD is the initial
demand curve with price OP and output OQ. Due to selling cost
demand curve shifts to the right to D 1D1and further to D 2D2.T h e
producer is able to sell more quantity OQ 1and OQ 2at the same
price OP.
Second diagram shows that DD is the original demand curve
without selling cost with price OP and quantity OQ. If selling cost is
incurred, demand curve will b ecome more elastic. ie D1D1. If firm
reduces price to OP1, its demand will increase to OQ2. But at the
same time firm incurs the selling cost, it will be able to sell more i.e.
OQ 1at price OP 1.munotes.in
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81Effect of selling cost on profit
Effect of selling cost on profit can be explained with the help
of following diagram
Diagram 5.8
In the above diagram X axis represents output and Y axis
represents cost and revenue. If we consider a case without selling
cost, AR and MR are the downward sloping curves starting at a
lower side of Y axis. APC and MPC are the average and marginal
production curves. Initial equilibrium point is E where MPC curve
and MR curves intersect. Equilibrium output= OQ and price = OP,
TR = OQRP, TC = OQNM as TR>TC, profit = MNRP.
If the fir m incur selling cost, demand for goods will increase
and therefore AR curve shifts upward to AR 1. Correspondingly MR
curve will also shift to MR 1. Adding selling cost in production cost
we have the average and marginal cost curves. New equilibrium
point is E1. Output = OQ 1, price = OP 1,T R=O Q 1R1P1,T C=
OQ 1N1M1.T R > T C ,t h e r e f o r ep r o f i t=M 1N1R1P1.
This shows that due to selling cost demand for commodity
increases from OQ to OQ1. An increase in demand raises the price
from OP to OP1. And therefore profit after selling cost is also
greater than the level of profit before selling cost.11 1 1MNRP M N R P
6.4. ROLE OF ADVERTISEMENT
Due to the availability of close substitute products,
advertisement or selling cost plays an important role under
mono polistic competition. These advertisements are undertakenmunotes.in
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82through exhibitions, T.V, hoardings, discounts, distribution of free
samples etc. The purpose of selling cost is to increase the sale of
commodity in the market. It also encourages competition among
the firms producing close substitute products.
There are many advertisements which gives an information
about the availability of various products in the market and also
inform them about quality and uses of the product. Advertisement
also specifies the benefits of using a particular product. Such
advertisements are called informative or educative advertisement.
On the other hand there are some advertisements who distort
consumer’s preferences by misleading them to purchase certain
commodities. Such adver tisements are called manipulative or
competitive advertisement.
There are debates over its role which is discussed as
follows -
Arguments for advertisement or benefits of advertisement:
•Advertisement creates awareness amongst the consumers
about the avail ability of various products, their advantages and
disadvantages, price of the product etc.
•Advertisement generally increases the demand for the product
and thereby increases the level of investment and employment.
•Successful advertisement which leads to in crease in demand
will lead to increase in production of the firm and thereby greater
benefits of economies of scale.
•Advertisement directly provides information to the consumers
and thus eliminates middlemen.
•If the advertisement is genuine and people ar eh a p p yw i t ht h e
quality of the product, firms will succeed in building a brand
loyalty among the consumers.
Arguments against advertisement or disadvantages of
advertisement:
•Advertisement creates temptation to spend money on those
goods which are someti mes not required.
•In order to attract consumers, sometimes producer explains
false qualities of their product where the consumers do not have
any source of verifying. In this way advertisement misleads the
consumers.
•Advertising costs are added to the pro duction cost of the firm
and therefore price of the product will also be high.
•Advertising cost leads to psychological dissatisfaction to many
poor people for whom it is not affordable to consume advertised
product.munotes.in
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83•If an advertisement is not successful i n increasing demand for a
product, advertisement expenditure will be considered as
wastage.
•Posters on wall for advertisement spoils the beauty of specific
areas.
•Due to attractive advertisement many people consume food
items (junk food) in large quantit y.
•Advertisements by the financial institutions offering loans at a
concessional rate for consumption of specific goods divert
peoples mind to consume such goods. But at the time of
repayment of loan if they face some problem, it leads to stress,
family pr oblems etc.
•In most of the advertisements female models are shown. In
some cases there is an exploitation of these models.
Check your Progress :
1)Suppose there are fairly large numbers of a firm producing
detergent powder. Each firm spends huge amount of money on
advertisement to increase the sale of their product in the
market. Identify the market structure for the detergent powder.
2)Explain the role of advertisement.
3)If you want to sale of your product under the monopolistically
competitive ma rket, there is a need of selling cost. Justify your
answer.
6.5 WASTAGES UNDER MONOPOLISTIC
COMPETITION
There are different types of wastages under monopolistic
competition. These are discussed below.
1.Excess capacity -Excess capacity is crea ted under
monopolistic competition the equilibrium of a firm under
monopolistic competition is attained at a less than optimum level
of output. This means that the resources are not fully utilized
and therefore this underutilization of existing capacity le ads to
excess capacity. Following diagram explains the case of excess
capacity.munotes.in
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84
Diagram 5.9
In the above diagram horizontal AR and MR curve indicates
perfect competition and downward sloping AR and MR curves
indicates monopolistic competition. It is cle ar from the diagram that
equilibrium under perfect competition is attained at point E with
price OP and output OQ. Whereas equilibrium under monopolistic
competition is attained at point E1, with price OP1 and output OQ1.
This shoes that firm under perfect competition produces optimum
level of output (OQ) with minimum cost and thus charges lower
price (OP). On the other hand under monopolistic competition
produces less than optimum level of output (OQ1) and sells at a
higher price (OP1). As firm produces le ss than optimum level of
output, Q1Q capacity of the form is unused. This is the excess
capacity of the firm under monopolistic competition.
•As there is underutilization of a capacity, it leads to the problem
of unemployment.
•If the firm is not successful in increasing demand for their
product in the market, all firms expenditure in the form of selling
cost will be a wastage.
•Heavy expenditure on advertisement will increase the prices of
goods and services and therefore there is an exploitation of the
consumers.
2.Unemployment -as the production capacity of a firm is not fully
utilized under monopolistic competition, the problem of
unemployment occurs in case of monopolistic competition.
3.Exploitation of the consumer -Due to product differentiation,
firm ha s to incur selling cost under monopolistic competition.
Therefore the consumers have to pay higher price for the
product and this leads to exploitation of the consumers.munotes.in
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854.Selling cost -Under monopolistic competition firm undertakes
huge expenditure on advert ising their product in order to
increase the sale of their product in the market. If the firm is not
successful in increasing the sale of their product in the market,
this expenditure is considered as the wasteful expenditure.
5.Lack of specialization -as there are many firms, producing
close substitute products, there is a very little scope for
specialization. Thus the advantages of large scale production
are not possible.
6.6SUMMARY
This unit studies the monopolistically competitive market .I t
includes the features of monopolistic competition. The concept of
monopolistic competition was introduced by professor chambertin.
Monopolistic competition is a more realistic market structure in
which we live. This unit discusses the equilibrium of a firm in the
short run and in the long run. It concentrates on product
differentiation and also explains the factors that leads to product
differentiation.
This unit explains selling cost as an important feature of
monopolistic competition. It shows the effects of sell ing cost on
demand for a commodity and profit of the firm with the help of
diagrams. It also explains excess capacity and wastages under
monopolistic competition.
6.7QUESTIONS
1. Discuss the features of monopolistic competition.
2. Write a note on prod uct differentiation.
3. Explain the short run equilibrium of a firm under monopolistic
competition.
4. Discuss the long run equilibrium of a firm under monopolistic
competition.
5. Bring out distinguish between production cost and selling cost.
6. What are the various forms of selling cost.
7. Explain with the help of diagram effects of selling cost.
8. Discuss the effect of selling cost on profit.
9. Discuss the role of advertising.
10. What are the arguments for and against advertising.
11. Write a note on wastages under monopolistic competition.
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867
OLIGOPOLISTIC MARKET
Unit Structure :
7.0 Objectives
7.1 Features of oligopoly
7.2 Collusive and non -collusive oligopoly
7.3 Summary
7.4 Questions
7.0 OBJECTIVES
•To understand thefeatures of oligopoly
•To understand the difference between collusive and non -
collusive oligopoly models
•To understand the types of collusions
•To understand theprice leadership ,its types and limitations.
7.1 OLIGOPOLY MARKET CAN BE WELL
UNDERSTOOD WITH THE HELP OF FOLLOWING
CHARACTERISTICS -
•Few sellers -In case of oligopoly market there are few sellers.
The number of sellers is not more than 10. In case if there are
more than ten sellers, few sellers are dominant and others are
insignificant.
•Homogeneous or diff erentiated products -goods which are
sold under oligopoly are either homogeneous or differentiated.
Differentiation is in the form of brand name, design, color etc.
•Entry is possible but difficult -In case of oligopoly a new firm
can enter the market but in reality, it is difficult because of the
technological, financial and other barriers
•Interdependence -as there are few firms under oligopoly, a
single firm is not in a position to take any decision about price
and output independently. Any decision taken by one firm has
the reactions from the rival firms or competitive firms. Different
firms will have different decisions. Thus the firms are
interdependent. Therefore it is necessary for the firm to take in
to consideration the possible reactions of the riv al firms.
•Uncertainty -as the firms are interdependent for deciding the
price and output, it creates the atmosphere of uncertainty. If onemunotes.in
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87seller increases his output to capture large share of the market,
others will react in the same way. If one seller i ncreases the
price of his product, others will not follow him due to the fear of
losing the market. On the other hand if one seller reduces the
price, others will also reduce their prices. But how much price
reduction they will do is uncertain. This means that an
oligopolist is uncertain about the reactions of the competitive
firms.
•Indeterminateness of the demand curve -in case of perfect
competition price is determined in the market with demand and
supply factors and the firm is a price taker therefore demand
curve of the firm is perfectly elastic (parallel to x axis). In case of
monopoly a single seller decides the price for his commodity
and accordingly sells his output. Thus the demand curve of the
monopolist slopes downward. And the demand curve is s teeper
as the substitute products are not available. Under monopolistic
competition as close substitute products are available, demand
curve is downward sloping and more elastic or flatter. This
means that under perfect competition, monopoly and
monopolist ic competition there is a definite shape of the
demand curve.
In case of oligopoly due to interdependence of firms and the
uncertainty aspect
Demand curve do not have a definite shape. It loses its
determinateness.
The demand cu rve under oligopoly is kinky as shown in the
following diagram.
Diagram 5A.1munotes.in
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88Check your Progress :
1)Suppose there are two firms which are interdependent on each
other for taking any decision related to price and output. There
is also and uncertaint y in the market. Identify the market
structure.
2)Give few examples of firms operating under Oligopoly.
7.2 COLLUSIVE AND NON -COLLUSIVE OLIGOPOLY
The oligopoly market faces the problem of price
determination because of the continuous react ions of the rival firms.
Due to differentiate products, competition in the oligopoly market is
also high. An oligopoly can be collusive or non -collusive.
Non collusive oligopoly
In case of non -collusive oligopoly, firms behave
independently, even tho ugh they are interdependent.
interdependence of the firm leads to stiff competition among the
rivals. In this case the behavior of the Seller depends on how he
thinks his competitors will react to his decision making. In case of
non-collusive oligopoly f irm while deciding price for its product
assumes that rival firms will keep their price and output constant
and will not react to any change in price and output introduced by
the firm. A very good example of non -collusive oligopoly is
sweezy’s kinked dem and curve model.
Collusive oligopoly -collusive oligopoly prevails when the firms
working under oligopoly market enter into an agreement regarding
uniform price and output policy to avoid uncertainty arising due to
interdependence of the firm and to avoid high level of competition.
The agreement may be either formal (open) or tacit (secret).
As the open agreement to form monopolies are illegal in most of
the countries agreements between the oligopolists are tacit.
Collusions are of two types:
•a. Cartel a nd b. price leadership
In case of collusive oligopoly, price fixing takes place when
all firms in the market try to control supply, to achieve a monopolymunotes.in
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89like situation. In this type of oligopoly, firms aim at maximizing
collective profit rather than indi vidual profit.
Collusive and non -collusive models are discussed below.
Price rigidity -kinked demand curve model (non -collusive
oligopoly model)
Kinky demand curve model or kinked demand curve
hypothesis was given by an American economist Paul M. Swee zy
and Oxford economist Hall and Hitch.
Interdependence and uncertainty aspect of oligopoly leads to
indeterminateness of the demand curve. In case of oligopoly price
is rigid or inflexible because oligopolists are not interested in
changing their price e ven though economic conditions undergo a
change.
In order to explain price and output determination under
oligopoly with product differentiation economists often used kinked
demand curve model. This model is explained by taking an
example of extremely lim ited case of oligopoly i.e. Duopoly, where
there are only two firms. Therefore there are two demand curves as
shown in the following diagram.
Diagram 5A.2
As shown in Diagram 5A.2above there are two demand
curves DD of firm A and D1D1 of firm B. Dem and curve DD is
more elastic where as demand curve D 1D1is less elastic. These
two demand curves intersect at point K. Thus the prevailing price is
OP and quantity is OQ. As shown in the diagram the demand
curve faced by an oligopolist is DKD 1.T h i sd e m a nd curve has a
kink at point K because the upper segment of demand curve
(segment DK is more elastic) and the lower segment of the demandmunotes.in
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90curve (segment KD 1) is less elastic. This difference in elasticities is
because of the reactions of the competitive fi rms.
An oligopolists believes that if he reduces the price below
prevailing price, his competitors will also reduce their prices and if
he increases the price above prevailing price, his competitors will
not increase their prices.
•Increase in price -If an oligopolistic increases the price above
prevailing price his competitors will not increase their price.
Therefore ,demand for his goods will fall substantially. This is
because due to increase in price his customers will go to his
competitors who have not increased their prices. Due to this the
demand curve abo veprevailing price is more elastic.
•Reduction in price -If an oligopolistic reduces the price below
prevailing price, his competitors will follow him and also reduce
their prices due to the fe ar of losing their customers. Due to
quick reactions of the oligopolists, whoever reduces the price,
demand for his goods increases by a very little amount.
Therefore the demand curve below prevailing price is less
elastic.
Therefore DKD 1is the kinked demand curve under oligopoly.
Due to differences in elast icity, a demand curve has a kink at point
K. Thus the demand curve under oligopoly is called kinky demand
curve.
Rigid price -With an increase in price, there is a fear of losing the
market and ther e is a very little benefit by reducing the price.
There fore an oligopolist is not interested in changing their price.
Thus price remains rigid or sticky under oligopoly.
Equilibrium of a firm
Equilibrium of a firm occurs when MR= MC. In case of oligopoly the
demand curve or the average revenue curve has a kin kat a
particular prevailing price. Therefore the MR curve of the firm has a
discontinuous portion as shown in the following diagram.munotes.in
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91
Diagram5A.3
In the above diagram DKD 1is the kinked demand cu rve
under oligopoly. The demand curve has the kin kat point K.
There fore MR curve which lies half way between AR curve and Y -
axis has a discontinuous portion RS. MR curve is discontinuous
because of the Kink to the demand curve. Discontinuous portion of
the MR curve depends on the difference in elasticities. Larger is the
difference in elasticities, longer will be the discontinuous portion of
the MR curve. MC is the marginal cost curve which passes through
discontinuous portion of the MR curve. Equilibrium of the oligopoly
form is achieved at a point where MR=MC. Therefore equilibrium
output is OQ and price is QK or OP. If MC increases or decreases,
there will be upward or downward Movement in the marginal cost
curve over the discontinuous portion of the M R curve. This will keep
price and output level constant at OP and OQ respectively.
Therefore the price remains rigid. If an oligopolistic increases
price over DK portion of the kinked demand curve, the Rivals will
not follow due to the fear of losing the market. Due to this
oligopolists will not increase price above OP. Similarly, no
oligopolist is interested in reducing the price because in this case
due to the continuous reactions of the rivals, demand increases by
a very small amount. Thus the demand c urve is inelastic.
Collusive oligopoly models:
In case of oligopoly there is interdependence of the firms
and there is also, uncertainty. In order to avoid uncertainty arising
out of interdependence, firms generally enter into an agreement to
follow a uniform price and output policy. This type of agreementmunotes.in
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92helps firms to avoid price wars and also stiff competition. The
agreement may be either formal (open) or tacit (secret). Open
agreements are illegal in most of the countries. Thus, the
agreements to form monopolies are in the form of tacit agreements.
This type of oligopoly is called collusive oligopoly. OPEC
(Organization of Petroleum Exporting Countries) is the best
example of this type of oligopoly. There are two types of collusions.
They are -a.carte la n db . price leadership Cartel -Cartel is an
agreement among the competitive firms to earn higher profits.
Cartels are formed in oligopoly market where the number of sellers
is few and they are selling homogeneous or differentiated products.
In this agre ement, the member firms may agree on price fixing,
market share division of profits etc. The cartels are of two types -
centralized cartel and market sharing cartel. In case of centralized
cartel there is a common Sales Agency which alone undertakes the
selling operations for all the forms who are party to the agreement.
Here the Central Administrative agency decides the product price,
distribution of output, profit sharing for all the firms. All firms agree
tosurrender their rights to Central Administrati veAgency for
earning maximum joint profits. This is known as perfect cartel.
Agreement under centralized cartel can be discussed with the help
of following diagram.
Diagram 5A.4
In the about figure first two diagrams shows the case of two
firms A and Band third diagram explains the case of industry.
Formation of cartel leads to Monopoly power and therefore AR and
MR of industry are downward sloping. As shown in figure 3,
summation MC is the marginal cost curve for an industry, which is
being derived by adding horizontally the marginal cost of curves of
two f irms MC1 and MC2. Total industries output is produced at a
point where summation MC= MR. Therefore, total output is OM and
the market price is OP. This is the price set by the centralized
authority.
Firm A sells OM 1output and Firm B cells OM 2output.
OM1+OM2=OM. Market price is charged by both the firms.munotes.in
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93therefore, price of firm A is OP1 and price of firm B is OP 2. Profit
for firm A is S 1K1M1P1and profit for firm B is S 2K2M2P2.T h i ss h o w s
that fir mAproduces and sells greater quantity as compared to firm
Band thus makes higher profits.
A type of cartel discussed above is very rare. In the real
world we generally have loose type of cartel. Here we have two
types of market sharing. They are -
a.Market sharing by non -price competition and
b. Market sharing by output quota
a. Market sharing by non -price competition -In case of
oligopoly ,due to interdependence of firms and uncertainty, price is
rigid i.e. firms follow a particular price and th ere is no tendency
either to increase or to reduce the price. At a uniform price firms are
free to produce and sell that level of output which will maximize
their profits. Here even though the firms are following same price
they are free to change the styl e of their product, style of
advertising the product, additional facilities or discounts may be
given. If all member firms have identical cost, they will be agreeing
to uniform monopoly price and this price will maximize their joint
profits. But if their c osts are different, cartel price will be decided by
the bargaining between the firms. If low cost firms are interested in
charging lower price cartel may break away.
b. Market sharing buy output quota -In this case an oligopoly firm
enters in to an agreem ent regarding quota of output to be produced
and sold by each of the firm at a particular agreed price.
If the cost of production is same for all the firms and firms
areproducing homogeneous product, a monopoly element will exist
and all firms will share the market equally and charge the maximum
possible price. On the other hand, if the cost of production is
different for different firms, market share of the firms will differ.
These differences are dependent on the bargaining power of the
firms. The Quota of output shared by the firm depends on the past
records and negotiation skills.
Another method for market sharing quota is to divide the
markets region wise. In this case firms are free to decide the price
and to bring changes in their product. When the re are cost
differences between the firms all types of cartels are unstable.
Price leadership:
Price leadership is one way of avoiding unnecessary
competition. In case of price leadership one firm decides the price
and the other follow it. Firms who decid es the price will be the
leader and the others are followers.munotes.in
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94There are different types of price leadership. They are
discussed below:
1) Price leadership by a low -cost firm -In this case a firm with
lower cost of production becomes the leader. Here a fir mw i t hl o w
cost sets a price and the other firms with higher cost of production
accept the price. While deciding price, low cost firm has to ensure
that this price brings some profits to the high cost firms.
2) Price leadership by a dominant firm -In thi s case one of the
firms in the oligopoly market may be producing a large portion of
the total output. Such a firm will become dominant, who can
influence other firms in the market. As other firms are small they
cannot have impact on the market. The dominan t firm fixes a price
which maximizes its own profit. Thus, the other firms will follow the
price set by the dominant firm and accordingly adjust their output.
3) Barometric price leadership -In this type of price leadership an
oldexperienced and most re spected firm in the market becomes
the leader. This firm study the changes in market conditions like
demand for the product, cost conditions, level of competition etc.
and decides such a price which protects the interest of all. A leader
firm decides the p rice which is beneficial to all and other firms
Follow the Leader.
4) Exploitative or aggressive price leadership -Here a large and
dominant firm establishes its leadership through aggressive price
policy and forces the other firms to follow the price se tb yh i m .I ft h e
firm's do not agree with the price, aggressive firms may threaten
the other firms to keep them out of the market.
Price leadership by a dominant firm In case of price
leadership by a dominant firm, one of the large and dominant firm in
the industry sets the price and the other small firms follow the price
set by the dominant firm. Following diagram explains the price
leadership by a dominant firm.munotes.in
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95
Diagram 5A.5
In the above diagram DD is the demand curve of a market at
and DL is the demand curve of a dominant firm, MR Lis the
marginal revenue curve and MC Listhe marginal cost of the
dominant firm. The dominant firm will maximize their profit when
MR L=M C L. Therefore, the price set by the dominant firm is Pd and
the output of the domi nant firm is Qd. As the small firms in the
market are price takers, they follow price Pd which is set by the
dominant firm. for the small firms, price set by the dominant firm
becomes their marginal revenue, Pd =MRs. The small firms or
followers will maxim ize their profit when MRs = summation MCs.
Thus, the output of small firms is Qs. Thus, in the market
consumers pay price Pd and consume quantity Q. Out of this total
quantity Q the share of dominant firm is Qd and the share of small
firms is Qs. Whether t he price leadership is successful or not
depends on various factors. It is expected that the leader or
dominant firm is fully aware of the reactions of the small firms. If the
leader firm takes the decision with incomplete information, firms’
leadership ma y not be successful. Some of the limitations of the
price leadership are as follows -
1) Non price competition -There is a possibility that even though
the small firms are following the price set by dominant firm, they
may also follow various non -price co mpetition methods, which are
in the form of discounts ,after sales services etc. In this case non
price competition may lead to reduction in prices to protect their
own market share.
2) Product differentiation -In case of oligopoly, if the firms are
sellingdifferentiated products, it is difficult to have the leadership.
This is because each firm will incur selling cost in order to attract
more customers. Selling cost is in the form of TV on newspapermunotes.in
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96advertising, giving free samples, discount, etc. This situation forces
the leader firm to enter into the competition and protect its market
share.
3) Difference in the cost of production -Cost of production for
each of the firm is different. In case of price leadership if the low
cost firm becomes leader an d sets the price, which other forms in
the industry have to follow. In this case for a dominant firm it is
difficult to follow the price set by low cost firm. If the firms with a
lower cost enter into non price competition it may lead to open
competition b y all the firms. On the other hand, if high cost firm
becomes the leader for setting the price it has to set high price for
its product in order to cover the cost firms who are not ready to
accept this high price may try to enter into non-price competitio nt o
enlarge their market.
7.3SUMMARY
This unit explains the characteristics of oligopoly market. It
explains two types of oligopoly models that is collusive oligopoly
and non -collusive oligopoly.
Non collusive oligopoly model is discussed with the hel po f
Paul sweezy's kinky demand curve. It explains why price remain
rigid under oligopoly. Equilibrium of a firm under oligopoly market is
also explained wit h the help of intersection of discontinuous
marginal revenue curve under oligopoly and marginal co st curve.
Collusive oligopoly is discussed with the help of cartels and
price leadership.
Two types of cartels are discussed that is centralised cartels
and market sharing cartels.
Two types of market sharing are
1)Market sharing by non -price competi tion and
2)Market sharing bye quota.
Four types of price leaderships are explained in this unit. They are
1) Price leadership by high cost firm
2) Price leadership by low cost firm
3) Barometric price leadership
4) Aggressive or exploitative price leade rshipmunotes.in
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977.4QUESTIONS
1. Discuss the features of oligopoly market.
2. What is oligopoly? Explain its characteristics.
3. Explain why price is rigid under oligopoly?
4. Discuss kinky demand curve under oligopoly.
5. Explain the collusive oligopoly m odels
6. Write a note on cartel.
7. What is price leadership? Explain its various types.
8. Discuss the price leadership by a dominant firm.
9. Discuss price leadership along with limitations.
10. Explain non -collusive oligopoly model.
munotes.in