CA-Foundation

Economics
 Index
SL. No. Chapter Name Page No.

1. Nature And Scope of Business Economics 01 – 16

2. Theory of Consumer Behavior 17 – 38

3. Theory of Demand 39 – 80

4. Theory of Production 81 – 96

5. Theory of Cost 97 – 108

6. Price Determination in Different Market 109 – 132

7. Business Cycle 133 – 139

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Nature And Scope of Business Economics

Economics is an important branch of social science, which deals with the behavior of human beings in relation
to economic activities. The term ‘Economics’ owes its origin to the Greek word ‘Oikonomia’ meaning
‘management of household’.

Economics is, thus, the study of how we work together to transform scarce resources into goods and services
to satisfy the most pressing of our infinite wants and how we distribute these goods and services among
ourselves.

In fact, out of social sciences, it is economics which has more practical applicability, hence regarded as “Queen
of Social Sciences”.

Economics, concerns itself not just with how a nation allocates to various uses its scarce productive resources
but it also deals with the process by which the productive capacity of these resources is increased.

In the day-to-day events, we come across several economic problems like changes in price of individual
commodities as well as general price level changes; economic prosperity and higher standards of living of
some people despite general poverty of the masses; problems of unemployment of certain class of persons or
in some areas. These are some of the matters connected with economic analysis. The study of Economics will
help in analyzing the possible causes contributing to these problems and might suggest a number of
alternative courses, which could be adopted for tackling these problems.

Consider the following situation.

It is your birthday and your mother gives you ` 1000 as birthday gift. You are free to spend the money as you
like. What will you do? You have many options before you, like:
Option 1: You can give a party to your friends and spend the whole money on them.
Option 2: You can buy yourself a dress for ` 1000.
Option 3: You can go for a movie and eat in some restaurant.
Option 4: You can buy yourself a book and save some money.

What do you notice? You have so many options before you. You will have to go for one option or a combination
of one or more options. But why can’t you have everything? Given the choice you would like to spend not only
on your friends, but would also like to see movie, eat in the restaurant, buy a dress and a book and save some
money. But you cannot. Why? Because you have only 1000 Rupees with you.
We can use our limited resources to satisfy only some of our wants, leaving many others unsatisfied.

The two fundamental facts of economics are that:

i) Human beings have unlimited wants; and
ii) The means of satisfying these wants are relatively scarce form the subject matter of Economics.

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Hence, economics is the study of how the society uses its limited resources to satisfy its infinite wants and
how these resources are distributed among different sections of the society.

Definition of Economics
Several definitions of Economics have been given by different authors. For the sake of convenience, let us
classify the various definitions into four groups:
a) Science of wealth or Classical Economics
b) Science of material well-being or Neo-classical Economics
c) Science of choice making by Lionel Robbins
d) Science of dynamic growth and development by Paul A. Samuelson
We shall examine each one of these briefly.

Science of wealth
Although the activity of acquiring and increasing material wealth is as old as civilisation, a disciplined study
of the wealth producing activities commenced back in 1776 when Adam Smith, the father of Economics,
published “The Nature and Causes of Wealth of Nations”. He defined Economics as: “An inquiry into the
nature and causes of wealth of nations.”
Many other classical economists also defined Economics:
According to J B Say, Economics is a “Science which deals with wealth”
According to J.S. Mill, economics is “The principle science of production and distribution of
wealth”.

Science of material well-being

Under this group of definitions, the emphasis is on welfare as compared with wealth in the earlier group.
According to Alfred Marshall

“Economics is a study of mankind in the ordinary business of life. It examines that part of
individual and social action which is most closely connected with the attainment and with the
use of the material requisites of well-being. Thus, it is on the one side a study of wealth and on
the other and more important side a part of the study of man.”

This definition was propounded by Prof. Alfred Marshall in his book “Principles of Economics”, published in
1890. This definition lays emphasis on welfare as compared to wealth.

Prof. Marshall clearly points that economics is first, a study of human welfare and only then is the emphasis
given on wealth. According to Prof. Alfred Marshall, wealth is a “mean” and welfare is an “end”.

According to A.C. Pigou “The range of our inquiry becomes restricted to that part of social welfare
that can be brought directly or indirectly into relation with the measuring rod of money”.

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Science of choice making

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

His definition is as follows:

“Economics is the science which studies human behavior as a relationship between ends and scarce means
which have alternative uses”.
a) Economics is a science: Economics studies human behaviour scientifically. It studies how human beings
use the scarce resources optimally under given constraints.
b) Human behaviour: this definition shifted the focus of economics on study of human behaviour bringing
to life the reasons behind as to when and how decisions are made by individuals in the quest of satisfying
their wants.
c) Unlimited ends: Ends refer to wants. It is a general human tendency that when one want is satisfied,
another want crops up. Thus, a choice has to be made between more important and less important wants.
d) Scarce means: Means refer to resources. Resources may be natural (oil, mineral ore) or man-made
(capital goods, consumer goods). Wants are unlimited, but the resources (means) to satisfy these wants
are limited.
Example: A construction firm wants to produce steel, iron and cement. It also wants to diversify
geographically, but the amount of capital it has is limited. The labour force is also limited. Availability of
steel and iron is also scarce. Hence, it has to restrict itself to the scarce means.
e) Alternative uses: Resources are not only scarce, but they can also be put to many uses. Thus, a choice has
to be made between the most urgent and the less urgent needs.
Example: coal can be used as a fuel for the production of industrial goods, it can be used for running
trains, and it can also be used for domestic cooking purposes and for so many other purposes.

It follows from the definition of Robbins that Economics is a science of choice. An important thing about
Robbin’s definition is that it does not distinguish between material and non material, and between welfare
and non-welfare. Anything which satisfies the wants of the people would be studied in Economics. Even
if a good is harmful to a person, it would be the subject matter of Economics if it satisfies his wants.

Science of dynamic growth and development.

Although the fundamental economic problem of scarcity in relation to needs is undisputed, it would not be
proper to think that economic resources - physical, human, financial-are fixed and cannot be increased by
human ingenuity, exploration, exploitation and development.

According to Prof. Samuelson “Economics is the study of how men and society choose, with or
without the use of money, to employ scarce productive resources which could have alternative

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uses, to produce various commodities over time and distribute them for consumption now
and in the future amongst various people and groups of society”.

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

and scarcity definition. It includes choice making in the present and in the future. Although the fundamental
economic problem of scarcity remains undisputed, Samuelson goes a step further and discuss how a society
uses limited resources for producing goods and services for present and future consumption of various people
or groups.

Business Economics may be defined as the use of economic analysis to make business decisions involving
the best use of an organization’s scarce resources.
Joel Dean defined Business Economics in terms of the use of economic analysis in the formulation of business
policies. Business Economics is essentially a component of Applied Economics as it includes application of
selected quantitative techniques such as linear programming, regression analysis, capital budgeting, break
even analysis and cost analysis.

Micro Economics
The term Micro Economics is derived from the Greek word ‘mikros’, meaning “small”. In Micro-Economics
we study the economic behavior of an individual, firm or industry in the national economy. It is thus a study
of a particular unit rather than all the units combined. It is basically concerned with the mechanism of
allocation of given resources. Further, it is a partial equilibrium analysis as it seeks to determine price and
output in an industry independent of those in other industries. We mainly study the following in Micro-
Economics:
i) Product pricing;
ii) Consumer behaviour;
iii) Factor pricing;
iv) Economic conditions of a section of the people;
v) Study of firms; and
vi) Location of industry.

Thus, when we are studying how a producer fixes the prices of his products, we are studying Micro-
Economics. Similarly, when we are studying why an industry is located at a particular place, we are studying
Micro-Economics.
Example:
a) Study of lock out at TELCO, finding causes of failure of A & Co.
b) How does the change of price of a good influence a family’s purchasing decisions? If wages rise, will the
person be inclined to work more hours or less hours?

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Macro Economics
The term Macro Economics is derived from the Greek word ‘makros’, meaning “large”.
It is the study of overall economic phenomena or the economy as a whole, rather than its individual parts.
Thus, in Macro-Economics, we study the economic behaviour of the large aggregates such as the overall
conditions of the economy such as total production, total consumption, total saving and total investment. It
includes:
i) National income and output;
ii) General Price level;
iii) Balance of trade and payments;
iv) External value of money;
v) Saving and investment; and
vi) Employment and economic growth.

Thus, when we study why we continue to have balance of payments deficits, or why the value of rupee vis à-
vis dollar is falling or why saving rates are high or low in a particular country, we are studying Macro-
Economics.
Micro approach Macro approach
1. Studies a particular part or a component of the economy Studies the economy as a whole
2. It is known as “Price Theory” It is known as “Income Theory”
3. Makes assumptions while studying an economy Doesn’t make any assumptions
4. It gives a worm’s eye view of an economy It gives a bird’s eye view of an economy
5. It is unrealistic study It is more realistic study
6. Has limited scope Has wider scope

Example: Study of per capita income of India, under-employment in the agriculture sector, savings of India
causes of inflation, etc.

It may be noted that the classification of Economics into micro and macro-economics is purely for analytical
purpose. In fact, there is really no opposition between micro and macro economics. Both are absolutely vital
and in most cases they play a complementary role, e.g. national income cannot grow unless the production in
individual firms and factories rises.
It is difficult to distinguish between the two terms as belonging to water-tight compartments.

What is macro from the national standpoint is micro from the world point of view. Similarly, what is micro
from a national angle becomes macro from a regional angle. Unless, we define what is the whole we cannot
say about a phenomenon whether it is micro or macro.

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Nature of Business Economics

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

The following points will describe the nature of Business Economics:

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

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

economic principles with regard to policy formulation, decision-making and future planning. However, if
the firms are to establish valid decision rules, they must thoroughly understand their environment.

This requires the study of positive or descriptive economic theory. Thus, Business Economics combines
the essentials of normative and positive economic theory, the emphasis being more on the former than
the latter.

Scope of Business Economics

The scope of Business Economics is quite wide. It covers most of the practical problems a manager or a firm
faces. There are two categories of business issues to which economic theories can be directly applied, namely:
1. Microeconomics applied to operational or internal Issues
2. Macroeconomics applied to environmental or external issues

Therefore, the scope of Business Economics may be discussed under the above two heads.
1. Microeconomics applied to operational or internal Issues
Operational issues include all those issues that arise within the organisation and fall within the purview
and control of the management. These issues are internal in nature. Issues related to choice of business
and its size, product decisions, technology and factor combinations, pricing and sales promotion,
financing and management of investments and inventory are a few examples of operational issues. The
following Microeconomic theories deal with most of these issues.
a) Demand analysis and forecasting: Demand analysis pertains to the behaviour of consumers in
the market. It studies the nature of consumer preferences and the effect of changes in the
determinants of demand such as, price of the commodity, consumers’ income, prices of related
commodities, consumer tastes and preferences etc.

Demand forecasting is the technique of predicting future demand for goods and services on the basis
of the past behaviour of factors which affect demand. Accurate forecasting is essential for a firm to
enable it to produce the required quantities at the right time and to arrange, well in advance, for the
various factors of production viz., raw materials, labour, machines, equipment, buildings etc. Business
Economics provides the manager with the scientific tools which assist him in forecasting demand.
b) Production and Cost Analysis: Production theory explains the relationship between inputs and
output. A business economist has to decide on the optimum size of output, given the objectives of the

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

2. Macroeconomics applied to environmental or external issues

Environmental factors have significant influence upon the functioning and performance of business. The
major macro economic factors relate to:
a) the type of economic system

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b) stage of business cycle

c) the general trends in national income, employment, prices, saving and investment.
d) Government’s economic policies like industrial policy, competition policy, monetary and fiscal policy,
price policy, foreign trade policy and globalization policies
e) working of financial sector and capital market
f) socio-economic organisations like trade unions, producer and consumer unions and cooperatives.
g) social and political environment.
Business decisions cannot be taken without considering these present and future environmental factors.
As the management of the firm has no control over these factors, it should fine-tune its policies to
minimise their adverse effects.

Central Economic Problems

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

What to produce?
As human wants are unlimited and resources are scarce and have various alternatives, an important decision
as to what goods are to be produced among various alternatives available and how much is to be produced
should be taken by the society so that there can be optimum utilization of scarce resources. What to produce
means, what type of goods to be produced? Whether to produce high quality or low quality goods? Whether
to produce more durable goods or perishable goods? Whether to produce more of consumer goods or capital
goods? This fundamental question to be decided, because, resources are scarce. If resources were abundant,
we might have produced all type of goods, without any worries.

How to produce?
After deciding what and how much to produce, the society has to decide the method of production i.e.,
whether it would use labour intensive techniques or capital intensive techniques. This decision is based on
the availability of the factors of production or we can say inputs i.e., labour and capital. How to produce

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involves three sub problems. They are: What resources to be used? Which technology to be used and Where
to be produce it?
Note:
- Labour intensive technique refers to the use of more labour in the production process.
- Capital intensive technique refers to the use of more number of machines compared to labour in the
production process.

For whom to produce?

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

Market provision are to be made for economic growth?

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

Types of economies
An economic system refers to sum total of arrangements for the production and distribution of goods and
services in a society. We divide all the economies into three broad classifications based on their mode of
production, exchange, distribution and the role which government plays in economic activity. These are:
- Capitalist economy
- Socialist economy
- Mixed economy

Capitalist economy
A capitalist economy is an economic system in which the production and distribution of commodities take
place through the mechanism of free markets. Hence, it is also called market economy or free trade economy
or laissez-faire. Each individual, be it a producer, consumer or resource owner, has considerable economic
freedom. In a market economy, there is no Government interference in economic affairs.
Example: The United States of America, Brazil, Japan etc.

The salient features of market economy are as follows:

- Right to private property: The various factors of production viz., land, labour, capital and enterprise
should be under private ownership. Inputs can be used by the owner as per their requirement.
However, the government is free to put restrictions for the benefit of the society.
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- Freedom of enterprise: This means that any individual is free to engage in any economic activity of
his choice. He is also free to start a new enterprise.
- Freedom to choice: This highlights consumer power. Consumers have the freedom to make choice.
Hence, producers should take utmost care to ensure that they produce only those goods which the
consumers are willing to buy.
Note: Consumer sovereignty means people are free to spend their income as they like.

- Profit motive: It is the main objective of a firm which induces people to work and to produce.
- Competition: There always exists competition among sellers to sell their goods and among buyers to
obtain those goods that satisfy their wants. Advertisements and discounts are tools used to handle
competition.
- Inequalities of income: Due to unequal distribution of wealth, there exists a wide gap between the
rich and the poor.

A capitalist economy’s solutions:

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

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Advantages of a capitalist economy:

- Increase in productivity: In a capitalist economy, ever farmer, trader or industrialist can hold
property and use it in any way he likes. He increases the productivity to meet his own self-interest. This,
in turn, leads to an increase in income, savings and investment.
- Welfare maximization: It is claimed that there is efficiency in production and use of resources to
optimum level. The self-interest of individuals also promotes the society’s welfare.
- Flexible system: The shortages and surpluses in the economy are generally adjusted by the forces of
demand and supply. Thus, it operates automatically through the price mechanism.
- Non-interference of the state: The State (government) has a minimum role to play. There is no
conflict between the individual interest and the society. The economic institutions function automatically
without the interference of the Government.
- Low cost and quality products: The consumers and producers have full freedom and therefore, it
leads to production of quality products at low costs.
- Technological improvement: The element of competition under capitalism drives the producers to
innovate something new to boost sales and thereby bring about progress.
- Awards men for dynamism: A capitalistic economy fosters research leading to better quality
products.

Disadvantages of a capitalist economy:

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

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- Exploitation of labour: Stringent labour laws are enacted to prevent the damages of capitalists. Hire
and fire policy will become the order of the day. Such laws also help to exploit the labour by keeping their
wage rate at its minimum level or subsistence level.
- Basic social needs are ignored: There are many basic social needs such as literacy, public health,
poverty, drinking water, social welfare and social security. As the profit margin in these sectors is low,
capitalists will not invest in these sectors. Hence, most of these vital human issues will be ignored in a
capitalist system.

Socialist economy
In a socialistic economy, the means of production are owned and operated by the State. All decisions
regarding production and distribution are taken by the central planning authority. Hence, the socialist
economy is also called as a planned economy or command economy. The government plays an active role
Social welfare is given importance; hence, equal opportunity is given to all.
Note: In today’s world there is no country which has controlled economy.

Features of a socialist economy:

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

Advantages of a socialist economy:

- Effective use of resources: The resources are utilized to produce socially useful goods without taking
the profit margin into account. Production is increased by avoiding wastage due to competition.
- Economic stability: A socialist economy is free from business fluctuations. Government plans well in
advance and everything is well coordinated to avoid over-production or unemployment. There is stability
because the production and consumption of goods and services are well-regulated.
- Maximization of social welfare: All citizens work for the welfare of the State. Everybody receives his
or her remuneration. The State concentrates on the production of basic necessaries instead of luxury

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goods. The State provides free education, cheap and congenial housing, public health amenities and social
security for the people.
- Absence of monopoly: The elements of corporation and monopoly are eliminated since there is an
absence of private ownership. The state is a monopoly, but produces quality goods at reasonable prices.
- Basic needs are met: In socialist economies, basic human needs like water, education, health, social
security, etc. are provided. Human development is more in socialist economies.
- No extreme inequality: As social welfare is ultimate goal, there is no concentration of wealth. Extreme
inequality is prevented in a socialist system.

Disadvantages of a socialist economy:

- Bureaucratic control: A socialist economy is operated under a centralized command and control
system. People here work out of fear of higher authorities. It does not give any initiative for the people to
work hard.
- No freedom: There is no freedom of occupation. Allocation of factors of production is not done
rationally. Jobs are provided by the State. Place of work is also provided by the State. The consumer’s
choice is very limited.
- Absence of technology: Work is monotonous and no freedom is provided. Any change in the
production process will alter the entire plan. Hence, any innovation cannot be enforced easily. Everything
is rigid and technological changes are limited.
- Absence of competition: Absence of competition makes the system inefficient.
- Less choice for consumer: As the production and distribution is in hands of the state, consumers have
less freedom of choice. Consumer have to choose from whatever the states produces.

Mixed economy
In a mixed economy, both public and private institutions exercise economic control. The public sector
functions as a socialistic economy and the private sector, as a free enterprise economy. All decisions regarding
what, how and whom to produce are taken by the state. The private sector produces and distributes goods
and services. Cost-benefit analysis is used to answer the fundamental questions – what, how and for whom
to produce?
Example: India

Features of a mixed economy:

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

Merits of Mixed Economy

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

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Demerits of Mixed Economy

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

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Theory of Consumer Behavior

All desires, tastes and motives of human beings are called wants in Economics. Wants may arise due to
elementary and psychological causes. Since the resources are limited, we have to choose between the urgent
wants and the not so urgent wants.

Characteristics of wants.
1. Wants are unlimited: Human wants are unlimited. They are never completely satisfied. When one
want is satisfied, another want will crop up to take its place.
2. Every want is satiable: Wants, in general, are unlimited. But a single or a particular want is satiable.
We can completely satisfy a single want.
3. Wants are competitive: wants generally compete with each other. We all have a limited amount of
money at our disposal. Therefore, we must choose some things and reject the others.
Example: Mr. X has Rs. 1000. With this amount, he has to choose between buying a book or having
food. Thus a utility maximizing consumer will choose the more urgent wants and distribute his income
on several goods in such a manner so as to get maximum satisfaction.
4. Wants are complementary: It is a common experience that we wants things in groups. A single article
out of a group cannot satisfy human wants by itself.
Example: A motor-car needs petrol and oil to start working. Thus, the relationship between motor-car
and petrol is complementary.
5. Wants are alternative: There are several ways of satisfying a particular want. If a person wants a chair
he may opt for either wooden or plastic chair. The final choice depends upon the availability of money
and the relative prices. These alternative goods are also called ‘substitutes’.
6. Wants vary with time, place and person: Wants are not always the same. They vary from one
individual to another. People want different things at different times and in different places. We require
hot tea or coffee in winter and cold drinks in summer. People of England require warn woollen suits and
rain coats. People of India require more of cotton cloths. The wants of a villager are different from that of
a businessman living in metropolitan city. So, wants vary with generation, culture, society, geographical
location and the extent of economic development.
7. Some wants are recurring: Some wants are recurring in nature. There are wants which get satisfied
but tend to recur time and again.
Example: We require food and water recurrently.
8. Wants become habits and customs: There are certain goods which do not form necessaries are
consumed on regular basis as the consumer is into a habit of consuming the same.
Example: Smoking of cigarette and alcohol

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Classification of wants
The existence of human wants is the basis of all economic activities in a society.
In Economics, wants are classified into three categories, viz., necessaries, comforts and luxuries.
Necessaries:
Necessaries are those which are essential for living. Man cannot do well with the barest necessaries of life
alone. Necessaries of efficiency helps a consumer to keep him fit for taking up productive activities. There are
other types of necessaries called conventional necessaries. By custom and tradition, people require some
wants to be satisfied.
Comforts:
Comforts refer to those goods and services which are not essential for living, but which are required for a
happy living. They lie between ‘necessaries’ and ‘luxuries’.
Luxuries:
Luxuries are those wants which are superfluous and expensive. They are not essential for living, however,
they may add efficiency to the consumer.

WANTS

Necessaries: Luxuries:
a) necessaries for life Comforts: After satisfying the comforts
b) necessaries of efficiency After satisfying the necessaries the consumer attempts to
satisfy luxuries
c) conventional necessaries the consumer demands comfort.

From time to time, different theories have been advanced to explain consumer behavior and thus to explain
his demand for the product. Predominantly the theory of consumer has been ruled by the following two
approaches.

a) Cardinal approach
b) Ordinal approach

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THEORY OF CONSUMER
BEHAVIOUR

Cardinal Approach Ordinal Approach

Cardinal Approach Ordinal Approach

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

Marginal Utility Analysis

This theory which is formulated by Alfred Marshall, a British economist, seeks to explain how a consumer
spends his income on different goods and services so as to attain maximum satisfaction.

Important Terms
Utility: Utility is the want satisfying power of a commodity. Demand for a commodity depends on
the utility it offers to the consumer. Utility means the level of satisfaction which people derive from the
consumption of a commodity.

Features of utility
a) It is a subjective entity and varies from person to person and moreover differs from time to time for the
same person.
b) It should be noted that utility is not the same thing as usefulness. Even harmful things like liquor, may be
said to have utility from the economic stand point because people want them. Thus, in Economics, the
concept of utility is ethically neutral.

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c) Utility is the anticipated satisfaction by the consumer, and satisfaction is the actual satisfaction derived.

Modes of creation of utility

Time utility- satisfaction derived from receiving the commodity at the right time. In other words the
consumer would derive a higher level of satisfaction if he is able to procure the commodity when he wants it.

Place utility- satisfaction derived by receiving the commodity at the right place. Utility discussed here is in
the form of convenience derived by the consumer in procuring the commodity.

Form utility- satisfaction derived by receiving the commodity in the right form. Getting the commodity in
a form usable by the consumer is another type of utility.

Types of utility
Marginal utility: It is the additional utility derived from the consumption of an additional unit of a
commodity. In short, Marginal utility = the addition made to the total utility by the addition of consumption
of one more unit of a commodity.
Total utility: It is the sum of utility derived from different units of a commodity consumed by a consumer.
In other words, Total utility = the sum total of all marginal utility.

Assumptions of Marginal Utility Analysis

a) The Cardinal Measurability of Utility: According to this theory, utility is a cardinal concept i.e.,
utility is a measurable and quantifiable entity. Thus, a person can say that he derives utility equal to 10
utils from the consumption of 1 unit of commodity A and 5utils from the consumption of 1 unit of
commodity B. Since, he can express his satisfaction quantitatively, he can easily compare different
commodities and express which commodity gives him greater utility or satisfaction and by how much.
According to this theory, money is the measuring rod of utility. The amount of money
which a person is prepared to pay for a unit of a good rather than go without it, is a measure
of the utility which he derives from the good.
b) Constancy of the Marginal Utility of Money: The marginal utility of money remains constant
throughout when the individual is spending money on a good. This assumption, although not realistic,
has been made in order to facilitate the measurement of utility of commodities in terms of money.
c) Independent units of a commodity have independent Utility: The total utility which a person
gets from the whole collection of goods purchased by him is simply the sum total of the separate utilities
of the goods. The theory ignores complementarity between goods.

Law of Diminishing Marginal Utility (LDMU)

One of the important laws under Marginal Utility analysis is the Law of Diminishing Marginal Utility.
The law of diminishing marginal utility is based on an important fact that while total wants of a person are
virtually unlimited, each single want is satiable i.e., each want is capable of being satisfied.

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Since each want is satiable, as a consumer consumes more and more units of a good, the intensity of his want
for the good goes on decreasing and a point is reached where the consumer no longer wants it.

The Law of Diminishing Marginal Utility is one of the very important and fundamental laws of consumption.
This is also known as “Gossen’s 1 st Law of Consumption”, named after an Austrian economist Gossen’s who
introduced it. This law is based on one of the important characteristic of human want i.e., “Some Human
wants could be satisfied”. Prof. Alfred Marshall has further developed LDMU.

Marshall stated the law as follows:“The additional benefit which a person derives from a given
increase in stock of a thing diminishes with every increase in the stock that he already has.”
In other words, as a consumer increases the consumption of any one commodity keeping constant the
consumption of all other commodities, the marginal utility of the variable commodity must eventually
decline.

It is to be noted that it is the marginal utility and not the total utility which declines with the
increase in the consumption of a good.

Assumptions to Law of Diminishing Marginal Utility (LDMU):

The LDMU is based on certain assumptions. They are
a) Homogeneous units: The different units of a particular commodity consumed by a person should
be identical or same in all respect i.e., color, size, quantity, taste, etc., The Units must be similar.
b) No time gap in consumption: In the process of consumption the successive units must be
consumed successively one after the other. If there is a long interval between the consumption of one
unit and the other unit, then LDMU will not hold good.
c) No changes in the taste, habits and the income of the consumer: During the course of
consumption there should not be any change in the taste, habits and income of the consumer. If there
is any change, this law will not hold good.
d) Cardinal measurability of utility: According to this theory, a person can express the satisfaction
he derives from the commodity in quantitative cardinal terms. In other words, utility can be expressed
in the form of numbers. The amount of money which a person is prepared to pay for a unit
of a good rather than go without it, is a measure of the utility which he derives from the
good.
e) Constancy of the Marginal Utility of money: This is an important assumption without which
Marshall could not have measured Marginal Utilities of goods in terms of money. It states that the
Marginal Utility of money remains constant throughout the period when the individual is spending
money on a commodity.
f) Independent units have independent utility: This assumption states that the Total Utility
which a person derives from a collection of goods purchased is simply the sum total of the separate

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utilities of goods i.e., separate utilities of different goods can be added to obtain the total sum of the
utilities of all the goods purchased.
g) Rationality: Here the consumer is assumed to be rational. The consumer will prefer to spend money
on the commodity from which he will derive maximum utils.

Number of cups of tea TU MU – TUn - TUn-1

1 50 50
2 75 25
3 95 20
4 110 15
5 120 10
6 120 0
7 100 -20

Let us illustrate the law with the help of an example. Consider the above table, in which we have presented
the total utility and marginal utility derived by a person from tea consumed by him. When one tea is taken
per day, the total utility derived by the person is 30 utils (unit of utility) and the marginal utility derived is
also 30 utils. With the consumption of 2nd tea per day the total utility rises to 50 but marginal utility falls to
20. We see that as the consumption of tea increases to 10 tea, marginal utility from the additional tea goes on
diminishing (i.e., the total utility goes on increasing at a diminishing rate). However, when the tea consumed
increases to 11, instead of giving positive marginal utility, the eleventh tea gives negative marginal utility (it
may cause him sickness).

Here, we may note that TU increases with the consumption of every successive units but at a diminishing
rate. On the other hand MU goes on diminishing with the consumption of every successive unit. When MU =
0, the TU will be the maximum. If a consumer goes on consuming beyond this point, the TU goes on
decreasing and MU will be negative.

Graphically we can represent the relationship between total utility and marginal utility
From the above table, we can conclude the three important relationships between total utility and marginal
utility
a) When total utility rises, the marginal utility diminishes.
b) When total utility is maximum, the marginal utility is zero.
c) When total utility is diminishing, the marginal utility is negative.

As will be seen from the figure provided below, the marginal utility curve goes on declining throughout and
the total utility curve increases initially. Till MU remains positive TU keeps on rising. As more units of the
commodity is consumed the TU keeps on increasing till the point MU becomes 0, at this point TU is
maximum. Thereafter we are able to see a fall in the TU as MU becomes negative.

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Exception to the Law

The law of diminishing marginal utility has the following exceptions.
Rare Collections: The law of LDMU is not applicable to some of the rare collections like stamps, coins, rare
currency, antique goods etc. because our satisfaction increases with every increase in the stock of these goods.
Not applicable to items of habit formation: The level of intoxication of the drinker increases with every
additional drink of liquor.
No applicable for money or asset class: The LDMU is not applicable for money or other asset class.
With every increase in the stock of money or asset class, the greed goes on increasing.

Criticisms of Law of Diminishing Marginal Utility (LDMU):

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

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Application of the Law of Diminishing Marginal Utility:

LDMU concept is used to explain “Value Paradox”: This “Value Paradox” was developed by Prof.
Adam Smith. This concept is also known as ‘Diamond –water paradox’. He says that water is more useful
than diamond, but it is priced low and diamond is less useful than water and it is priced high. This is because
more is the quantity or the stock of a product the marginal utility for such commodity is low and if the
availability of a product is less, marginal utility will be high.

Useful for Government to fix the Tax Rate: The value of additional money for a rich person is relatively
less. But whereas the value of the same additional money to a poor person is more. Hence the government
follows ‘Progressive Tax System’. Government levies high rate tax on rich people and low tax on poor people.
This approach of taxation is also based on LDMU.
To explain ‘Law of Demand’:The Law of diminishing marginal utility helps us to understand how a
consumer reaches equilibrium in case of a single good. It states that as the quantity of a good with consumer
increases, marginal utility of the good decreases. In other words, the marginal utility curve is downward
sloping. Now, a consumer will go on buying a good till the marginal utility of the good becomes equal to the
market price. In other words, the consumer will be in equilibrium (will be deriving maximum satisfaction) in
respect of the quantity of the good where marginal utility of the good is equal to its price. Here his satisfaction
will be maximum.
What happens when there is a change in the price of the good? When the price of the good falls, the equality
between marginal utility and price is disturbed. The consumer will consume more of the good so as to restore
the equality between marginal utility and price. When he consumes more of the good, the marginal utility
from the good will fall. He will continue consuming more till the marginal utility becomes equal to the new
lowered price.
On the other hand, when price of the good increases he will buy less so as to equate the marginal utility to the
higher price. We can say that the downward sloping demand curve is directly derived from
marginal utility curve.
Used to explain Consumer Surplus: Consumer surplus might be defined as the difference between the
price, what consumer is actually prepared to pay (MU) and the price that he actually pays. Initially a consumer
will be ready to pay more price for a product, gradually as the consumer consumes more number of units of
a commodity he will be ready to offer less price for the same product. This is because law of diminishing
marginal utility.

Consumer’s equilibrium with one commodity:

In an economy, where the commodities are available freely, the consumer will go on consuming a commodity,
till marginal utility becomes zero. At the point consumer gets maximum satisfaction and will be in
equilibrium.

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

Assumptions of the example:

a) Market Price of the commodity remains constant.
b) Law of Diminishing Marginal Utility operates.
c) No substitutes available. The consumer has to buy the same product.

In the above diagram, Marginal Utility curve slopes downward and market price remains constant.If the
consumer purchases2 units of commodity, at this level MUx>Px and this will induce him to purchase more.If
the consumer purchases 3units of commodity, at this level MUx = Px, consumer gets max satisfaction and
will be in equilibrium.If the consumer purchases 5unitsof commodity, at this level MUx<Px, consumer will
move into a negative zone.

The Law of Equi-Marginal utility (LEMU):

The idea of equi-marginal utility was first mentioned by H. H. Gossen (1810-1858) of Germany. Hence, it is
called Gossen’s second Law of consumption. Alfred Marshall made significant refinements to this law in his
‘Principles of Economics’.

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According to this law, the consumer will try to maximize his satisfaction when there are substitutes available
in the market. So, he will substitute one item in place of the other such that his Marginal Utility is proportional
to the price. The law of equi-marginal utility explains the behaviour of a consumer when he consumes more
than one commodity. Wants are unlimited, but the income which is available to the consumer to satisfy all
his wants is limited. This law explains how the consumer spends his limited income on various commodities
to get maximum satisfaction.

According to Alfred Marshall, “Other things being equal, a consumer gets maximum satisfaction when he
allocates his limited income to the purchase of different goods in such a way that the Marginal Utility derived
from the last unit of money spent on each item of expenditure tend to be equal”.

Assumptions to Law of Equi-Marginal Utility (LEMU):

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

Explanation of Law of Equi-Marginal Utility (LEMU)

Suppose there are two goods, A and B, on which a consumer has to spend a given income, the consumer being
rational, will try to spend his limited income on goods A and B to maximise his Total Utility or satisfaction.
Only at that point of maximum satisfaction, the consumer will be in equilibrium. According to the law of equi-
marginal utility, the consumer will be in equilibrium at the point where the utility derived from the last rupee
spent on each item is equal.
Symbolically, the consumer will be in the equilibrium when:-

𝑴𝑼𝒙 𝑷
= 𝑷𝒙 = MUm per unit of money income
𝑴𝑼𝒚 𝒚
𝒐𝒓
𝑴𝑼𝒙 𝑴𝑼𝒚
= = MUm per unit of money income
𝑷𝒙 𝑷𝒚

Where,
MUx = Marginal Utility of commodity X
MUy = Marginal Utility of commodity Y
Px = Price of commodity X

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Py= Price of commodity

MUm = Marginal Utility of money
Let us illustrate the law of equi marginal utility with the help of the following table:
Suppose a lady has a budget of Rs.40 with her, which she wishes to spend on two commodities, chocolates
and ice creams. The marginal utility derived from both these commodities is as under:
MU of Chocolates MU of Ice creams
Units MUx/Px MUy/Py
(X) (Y)
1 80 8 35 7
2 70 7 30 6
3 60 6 25 5
4 50 5 20 4
5 40 4 15 3
6 30 3 10 2
7 20 2 5 1
8 10 1 0 0

Note-if the consumer has unlimited budget then the most ideal scenario would be a combination of 8 units
of X and 7 units of Y as it would satisfy the condition of equilibrium assuming there is no constraint of
resources.
A rational consumer would like to get maximum satisfaction from Rs.40.
Px= Rs10 and Py= Rs 5. She can spend this money in three ways:
a) Rs.40 may be spent on chocolates only.
b) Rs.40 may be utilized for the purchase of ice creams only
c) Some amount may be spent on the purchase of chocolates and some on the purchase of ice creams.

If the prudent consumer spends Rs.40 on the purchase of chocolates, she gets 260utils by consuming 4 units
of chocolate.

If she spends Rs.40 on the purchase of ice creams, the total utility derived is 140 utils by consuming 8 units
of ice cream. Which is lesser than utility derived from consumption of chocolates.

In order to make the best of the available budget, she can purchase the following combinations as per the law
of equi marginal utility.
Combination Budget utilized Total utility
A= 2X + 1Y 25 185

B= 3X + 2Y 40 275

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Any combination above combination B would require more than the budget available. Thus, following the
𝐌𝐔 𝐱 𝐌𝐔𝐲
rule of equi marginal utility of =
𝐏𝐱 𝐏𝐲

The best possible combination available to the consumer with the limited budget available would be B= 3X +
2Y. With this available combination the consumer would be generating maximum total utility of 275 than any
other option.

Law OfEqui Marginal Utility

Limitations of Law of Equi-Marginal Utility (LEMU)

a) Rational behavior: It is true that consumer is irrational sometimes. It is behavior is greatly influenced
by habits, advertisements etc. Moreover a consumer has to keep a complete record of income and
continuously calculate the marginal utilities which is practically not possible.
b) Cardinal Measurement of Utility: Critics point out that utility is an abstract term, which cannot be
measured.
c) Utility is subjective: Utility is subjective and psychological concept. It is difficult to measure.
d) Marginal Utility of Money is not constant: Marshall assumes that marginal utility of money is
constant but Hicks argues that money is also a commodity and the marginal utility also diminishes slowly.
e) Multiplicity: Multiplicity of commodities prevent the consumer from making a rational choice. He
neither has time nor the ability to calculate marginal utilities.
f) Indivisible goods: It is not applicable to indivisible goods. There are certain goods such as fan, TV,
car etc., which cannot be divided or sub divided. If divided they will lose their utility.
g) Durable goods: It is difficult to measure the utility in respect of durable goods such as car and
machinery. For example: if the consumer purchases a car and a cup of tea, it is very difficult to equalize
the Marginal Utility of a car which lasts for several years with a cup of tea, which exhausts at the single
act of consumption.
h) Customs, fashions, ignorance, scarcity etc. Customs make the consumption of an article
compulsory irrespective of marginal utilities. Fashion of the day impede the operation of the law as one
may purchase a commodity much against his wish to tune with the fashion. Consumer does not possess

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complete knowledge of all commodities and their prices in the market. Moreover prices are subject to
change. Scarcity consumer is compelled to purchase an alternative or a substitute good if there is scarcity.

Importance of Law of Equi-Marginal Utility (LEMU)

The law of Equi-Marginal utility is not only theoretical, but also has practical application in our daily life.
Some of the areas, where it could be used are:
The Theory of Consumption: The expenditure pattern of every consumer is based on this law. The
consumer distributes his limited income among various commodities in such a way that the Marginal Utility
or the satisfaction that he gets is equal MU from the last rupee spent. At that point he stops further
consumption, because he knows that if he continues consumption, the satisfaction will be less and the price
he is going to pay is more. This helps the consumer to maximize his satisfaction.

Choice between Savings and Consumption: If the future consumption yields more satisfaction than
the present consumption, in the case the consumer will decide to save his income rather than spending it.

Scarcity aspect: This law applies to all fields of economic activity where limited resource are to be profitably
employed. Thus the law has very wide application. Prof. Marshall puts the significance of the law in the
following words: “The application of this principle could be extended to every field of economic enquiry”.

Consumer’s Surplus
The concept of consumer’s surplus was evolved by Alfred Marshall. This concept occupies an important place
not only in economic theory but also in economic policies of government and in decision-making of
monopolists.
It has been seen that consumers generally are ready to pay more for certain goods than what they actually
pay for them. This extra satisfaction which consumers get from their purchase of goods is called by Marshall
as consumer’s surplus.
Marshall defined the concept of consumer’s surplus as the “excess of the price which a
consumer would be willing to pay rather than go without a thing over that which he actually
does pay”, is called consumer’s surplus.”

Thus consumer’s surplus = what a consumer is ready to pay - What he actually pays.

Or

Thus consumer’s surplus = marginal utility - What he actually pays.

The concept of consumer’s surplus is derived from the law of diminishing marginal utility. As we know from
the law of diminishing marginal utility, as we purchase more of a good, its marginal utility goes on
diminishing. The consumer is in equilibrium when marginal utility is equal to given price i.e., he purchases
that many number of units of a good at which marginal utility from the last unit is equal to its price (It is

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assumed that perfect competition prevails in the market). Since the price is the same for all units of the good
he purchases, he gets extra utility for all units consumed by him except for the one at the margin.
This extra utility or extra surplus for the consumer is called consumer’s surplus.
It is often argued that the surplus satisfaction cannot be measured precisely. In case of very essential goods
of life, utility is very high but prices paid for them are low giving rise to infinite surplus satisfaction(example-
water). Further, it is difficult to measure the marginal utilities of different units of a commodity consumed by
a person.
No. of units Marginal Utility Price Consumer’s Surplus
1 30 20 10
2 28 20 8
3 26 20 6
4 24 20 4
5 22 20 2
6 20 20 0
7 18 20 –

We see from the above table that when consumer’s consumption increases from 1 to 2 units, his marginal
utility falls from Rs30 to Rs 28. His marginal utility goes on diminishing as he increases his consumption of
good X. Since marginal utility for a unit of good indicates the price the consumer is willing to pay for that
unit, and since price is assumed to be fixed at Rs 20, the consumer enjoys a surplus on every unit of purchase
till the 6th unit. Thus, when the consumer is purchasing 1 unit of X, the marginal utility is worth Rs 30 and
price fixed is Rs 20, thus he is deriving a surplus of Rs 10. Similarly, when he purchases 2 units of X, he enjoys
a surplus of Rs 8 [Rs 28 – Rs 20]. This continues and he enjoys consumer’s surplus equal to Rs 6, 4, 2
respectively from 3rd, 4th and 5th unit. When he buys 6 units, he is in equilibrium because his marginal
utility is equal to the market price thus he enjoys no surplus. Thus, given the price of Rs 20 per unit, the total
surplus which the consumer will get, is Rs 10 + 8 + 6 + 4 + 2 + 0 = Rs30.

Consumer Surplus

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The concept of consumer’s surplus can also be illustrated graphically. Consider the above figure, On the X-
axis we measure the amount of the commodity and on the Y-axis the marginal utility and the price of the
commodity. MU is the marginal utility curve which slopes downwards, indicating that as the consumer buys
more units of the commodity, its marginal utility falls. Marginal utility shows the price which a person is
willing to pay for the different units rather than go without them. If OB is the price that prevails in the market,
then the consumer will be in equilibrium when he buys OE units of the commodity, since at OE units,
marginal utility is equal to the given price OE. The last unit, i.e., 6thunit does not yield any consumer’s surplus
because here price paid is equal to the marginal utility of the 6 thunit. But for units before 6thunit, marginal
utility is greater than price and thus these units fetch consumer’s surplus to the consumer.
The total utility is equal to the area under the marginal utility curve up to point C i.e. OACE.
But, given the price equal to OB, the consumer actually pays OBCE. The consumer derives extra utility equal
to BAC which is nothing but consumer’s surplus.

Limitations
a) Consumer’s surplus cannot be measured precisely - because it is difficult to measure the marginal utilities
of different units of a commodity consumed by a person.
b) In the case of necessaries, the marginal utilities of the earlier units are infinitely large. In such case the
consumer’s surplus is always infinite.
c) The consumer’s surplus derived from a commodity is affected by the availability of substitutes.
d) There is no simple rule for deriving the utility scale of articles which are used for their prestige value (e.g.,
diamonds).
e) Consumer’s surplus cannot be measured in terms of money because the marginal utility of money changes
as purchases are made and the consumer’s stock of money diminishes.
f) Marshall assumed that the marginal utility of money remains constant. But this assumption is unrealistic.
g) The concept can be accepted only if it is assumed that utility can be measured in terms of money or
otherwise. Many modern economists believe that this cannot be done.

Indifference Curve Analysis

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

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in Marshall’s utility analysis. In this approach, it is felt that it is much easier and scientifically more sound to
order preferences than to measure them in terms of money.
Based on the quality and the level of satisfaction, consumer arranges different combination of goods in the
order of preference. This kind of conceptual ordering is technically known as “Scale of Preference”.
The consumer preference approach is, therefore, an ordinal concept based on ordering of preferences
compared with Marshall’s approach of cardinality.

Indifference curve-An indifference curve is a curve which represents all those combinations of two goods
which give same satisfaction to the consumer. Since all the combinations on an indifference curve give equal
satisfaction to the consumer, the consumer is indifferent among them. In other words, since all the
combinations provide the same level of satisfaction the consumer prefers them equally and does not mind
which combination he gets.

Assumptions in Indifference Curve Approach

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

Explanation of indifference curve

To understand indifference curve, let us consider the example of a consumer who has oneunit of burger and
21 units of cold drink. Now, we ask the consumer how many units of cold drinkhe is prepared to give up to
get an additional unit of burger, so that his level of satisfaction does not change. Suppose the consumer says
that he is ready to give up 6 units of cold drink to get an additional unit of burger.
We will have then two combinations ofburger and cold drink giving equal satisfaction to consumer:
Combination A which has 1 unit ofburger and 21 units of cold drink, and combination B which has 2 units of
burger and 15 units of cold drink. Similarly, by asking the consumer further how much of cold drink he will
be prepared to forgo for successive increments in his stock of burger so that his level of satisfaction remains
unaltered, we get various combinations as given below:
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Indifference Schedule
Combination Burger (X) Cold drink (Y) MRSxy
A 1 21 -
B 2 15 6
C 3 10 5
D 5 6 2
E 8 3 1
F 12 1 0.50

Now, if we draw the above schedule we will get the following figure.

An indifference curve IC is drawn by plotting the various combinations of the indifference schedule. The
quantity of burger is measured on the X axis and the quantity of cold drink on the Y axis. As in indifference
schedule, the combinations lying on an indifference curve will give the consumer the same level of
satisfaction.
Hence indifference curve is a locus of points representing all those different combinations of two goods, which
yield the same level of satisfaction to the consumer. Hence it is also known as ‘Iso-Utility Curve’.

Marginal Rate of Substitution: Marginal Rate of Substitution (MRS) is the rate at which the consumer
is prepared to exchange goods X and Y. Moreover when we refer to MRSxy it indicates the number of units
of commodity Y sacrificed for gaining a unit of commodity X. Considerthe above table, in the beginning the
consumer is consuming 1 unit of burger and 21 units of cold drink. Subsequently, he gives up 6 units of cold
drink to get an extra unit of burger, his level of satisfaction remaining the same. The MRSxy here is 6. Likewise
when he moves from B to C and from C to D in his indifference schedule, the MRS are 5 and 2 respectively.
Thus, we can define MRS of X for Y as the amount of Y whose loss can just be compensated by a unit gain of
X in such a manner that the level of satisfaction remains the same. We notice that MRS is falling i.e., as the
consumer has more and more units of burger, he is prepared to give up less and less units of cold drink. There
are two reasons for this.

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1) The want for a particular good is satiable so that when a consumer has more of it, his intensity of want for
it decreases. Thus, when the consumer in our example, has more units of burger, his intensity of desire
for additional units of burger decreases.
2) As the stock of particular commodity goes on depleting the consumer wants to sacrifice less of it. In our
example we noticed that as the stock of cold drink goes on decreasing the consumer is willing to sacrifice
less of it.

Properties of Indifference Curves: The following are the main characteristics or properties of
indifference curves:
i) Indifference curves slope downward to the right: This property
implies that when the amount of one good in the combination is increased,
the amount of the other good is reduced. This is essential if the level of
satisfaction is to remain the same on an indifference curve.

ii) Indifference curve is convex to the origin: It has been observed that as more and more of one
commodity (X) is substituted for another (Y), the consumer is willing to part with less and less of the
commodity being substituted (i.e. Y). This is called diminishing marginal rate of substitution. Thus, in
our example of burger and cold drink, as a consumer has more and more units of burger, he is prepared
to forego less and less units of cold drink.
This happens mainly because the want for a particular good is satiable and as a person has more and more
of a good, his intensity of want for that good goes on diminishing. This diminishing marginal rate of
substitution gives convex shape to the indifference curves.
iii) Indifference curves can never intersect each other: No two
indifference curves will intersect each other although it is not
necessary that they are parallel to each other. In case of intersection
the relationship becomes logically absurd because it would show that
higher and lower level indifference curve show equal level of
satisfaction which is not possible.
IC1 and IC2 intersect at A. Since A and B lie on IC1, they give same
satisfaction to the consumer. Similarly since A and C lie on IC2, they
give same satisfaction to the consumer. This implies that combination B and C are equal in terms of
satisfaction. But a glance will show that this is an absurd conclusion because certainly combination C is
higher and hence better than combination B because it contains more units of commodities X and Y. Thus
we see that no two indifference curves can touch or cut each other.

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iv) A higher indifference curve represents a higher level of

satisfaction than the lower indifference curve: This is
because combinations lying on a higher indifference curve
containmore of either one or both goods and more goods are
preferred to less of them.

v) Indifference curve will not touch either axes Another

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

vi) Indifference curve cannot be upward sloping: An upward

sloping indifference curve is not possible as it indicates that the
consumer is deriving equal amount of satisfaction with higher
quantities of either good X or Y or both. As the quantity of the
commodities increase it will lead to a higher level of satisfaction.

Unusual indifference curves

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

Perfect complements:- In case of perfect complements we come

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

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Horizontal indifference curve:- This type of indifference curve

is observed when the consumer does not consume one of the
commodities. Considering an example of a vegetarian who derives
no utility from meat would find no change in his level of satisfaction
if offered more units on meat. In our example meat is a neuter
commodity.

Indifference Map
The collection of indifference curves/the family of indifference curves, is known as “Indifference Map”. In an
indifference map, an Indifference curve at the extreme right represents highest level of satisfaction and the
curve at the extreme left represents lowest amount of satisfaction. Hence IC 4> IC3> IC2> IC1.
An indifference map depicts the complete picture of consumer’s tastes and preferences. In the given figure,
an indifference map of a consumer is shown which consists of three indifference curves.
We have taken good X on X-axis and good Y on Y-axis. It should be noted
that while the consumer is indifferent among the combinations lying on
the same indifference curve, he certainly prefers the combinations on the
higher indifference curve to the combinations lying on a lower
indifference curve because a higher indifference curve signifies a higher
level of satisfaction. Thus, while all combinations of I1 give him the same
satisfaction, all combinations lying on I2 give him greater satisfaction
than those lying on I1.

Budget Line
Price line/budget line represents all the different combination of two goods that can be purchased by the
consumer at a given level of income and prices of two goods.
A higher indifference curve shows a higher level of satisfaction than a lower one. Therefore, a consumer, in
his attempt to maximize satisfaction will try to reach the highest
possible indifference curve. But in his pursuit of buying more and
more goods and thus obtaining more and more satisfaction, he has
to work under two constraints:
a) First, he has to pay the prices for the goods and,
b) Second, he has a limited money income with which to purchase
the goods.
These constraints are explained by the budget line or price line. All those combinations which are within the
reach of the consumer (assuming that he spends all his money income) will lie on the budget line.

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Consumer’s Equilibrium under indifference curve

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

To show which combination of two goods X and Y the consumer will

buy to be in equilibrium we bring his indifference map and budget
line together.

Consider the above Figure, in which IC1, IC2 and IC3, are shown
together with budget line AB for good X and good Y. Every
combination on the budget line AB costs the same. Thus
combinations E, F and G cost the same to the consumer. The
consumer’s aim is to maximize his satisfaction and for this, he will try to reach highest indifference curve.

Since there is a budget constraint, he will be forced to remain on the given budget line, that is he will have to
choose combinations from among only those which lie on the given price line.

Which combination will he choose? Suppose he chooses E. We see that E lies on a lower indifference curve
IC1, when he can very well afford F lying on higher indifference curve. Similar is the case for other
combination on IC1. Again, suppose he chooses combination G lying on IC1, here again we see that the
consumer can still reach a higher level of satisfaction remaining within his budget constraints i.e., he can
afford to have combination F lying on IC2because it lies on his budget line. Now, what if he chooses
combination F? We find that this is the best choice because this combination lies not only on his budget line
but also puts him on the highest possible indifference curve i.e., IC2. The consumer can very well wish to
reach IC3 but this indifference curves are beyond his reach given his money income. Thus, the consumer will
be at equilibrium at point F on IC2. What do we notice at point F? We notice that at this point, his budget line
AB is tangent to the indifference curve IC2. In this equilibrium position (at F), the consumer will buy OC1 of
X and OC2 of Y.
At the tangency point F, the slopes of the price line AB and the indifference curve IC2are equal.
The slope of the indifference curve shows the marginal rate of substitution of X for Y.

Therefore we can conclude that at the point of equilibrium the consumer would be having the following
equation.

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𝐏𝐱
= MRSxy
𝐏𝐲

Convergence of marginal utility analysis and indifference curve analysis

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

𝐏𝐱
Whereas equilibrium as per the indifference curve approach is attained at = MRSxy
𝐏𝐲

𝐌𝐔 𝐱 𝐏𝐱
Thus, at the point of equilibrium = = MRSxy
𝐌𝐔 𝐲 𝐏𝐲

The indifference curve analysis is superior to utility analysis:

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

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Theory of Demand

Theory of Demand
This theory shows how consumer preferences determine consumer demand for commodities. Moreover an
insight into this topic will help us understand reasons behind a number of phenomenon occurring in the real
world scenario.

Meaning of demand- Demand refers to the quantity of a good or service that the consumers are willing and
able to purchase at various prices during a period of time.

Demand, in Economics, is something more than desire to purchase though desire is one element of it. A
beggar, for instance, may desire food, but due to lack of resources to purchase it, his demand is not effective.
Thus, effective demand for a thing depends on
i) Desire for the goods/service
ii) Means to purchase and
iii) Willingness to use those means for that purchase.
Unless demand is backed by purchasing power or ability to pay, it does not constitute demand.

Two things are to be noted about quantity demanded of a commodity.

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

Demand for a good is determined by the following

factors Price of commodity: Ceteris paribus i.e. other things
being equal, the demand for a commodity is inversely related to its
price. Thus, if price increases, demand decreases and vice-versa.
This is mainly due to income effect and substitution effect. This
phenomenon is known as the law of demand. Thus when price a
commodity effects its demand there would be a movement along
the demand curve better known as change quantity in demand. It is also termed as “price demand”.

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Price of related commodities:

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

(Cars are the commodity in question)

Example: If the price petrol (a complementary commodity to cars) increases, then the demand will fall
moreover it will also lead to a fall in demand for cars.

Note- A further analysis reveals a shift in the demand curve of Car and a movement along the demand curve
of petrol. The effect of a change in price of complementary goods will bring about a shift in the demand curve
of the commodity in question.

Substitute goods: Here, the commodities are used in place of another as alternative. A rise in the price of
one commodity will lead the consumers to shift to the purchase of the other commodity. If the price of a
commodity rises, it becomes relative expensive compared to other commodities. So, the consumers shift to
the purchase of the cheaper commodity in place of the commodity, the price of which has not changed. Such
goods are also known as substitutes. Price of one commodity and
demand for another commodity are directly related.
Example: If the price of Coke (a substitute of Pepsi) rises, relative to
the price of Pepsi, consumers will shift to the purchase of Pepsi from
coke, since it has now become comparatively cheaper. Thus we notice
an increase in demand of Pepsi due to a change in price of its
substitute coke. Coke and Pepsi are also known as substitute goods.

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(Commodity in question is Pepsi)

Note- A further analysis reveals a shift in the demand curve of Pepsi and a movement along the demand curve
of coca cola. The effect of a change in price of substitute commodity will bring about a shift in the demand
curve of the commodity in question. The impact of related goods on the demand of a commodity is termed as
“cross demand”.

Consumers’ income: Generally, higher the income of a consumer, higher is his purchasing power and thus,
higher is the quantity demanded. Thus, if the income of a consumer increases, he will demand more of the
good. However, there are certain commodities the demand of which falls with an increase in income. These
goods are called inferior goods. In case of necessities, the demand will rise initially, but will gradually
stabilize. This is because, people will become richer and their demand shifts from necessities to other durable
goods like T.V., house, car etc. We generally discuss two types of Income: (a) Money income and (b) Real
income. Money income deals with income of an individual in terms of money or cash. Real income deals with
the purchasing power of money income. The change in demand of a commodity due to income of the
consumer is termed as “income demand”

Normal goods Necessities Inferior goods

Tastes and preferences: Consumers’ tastes and preferences for various goods keep changing, thus
changing the demand for those goods. Demand would be high for those goods whose tastes and preferences
are greater. Change can also be due to changes in fashion. Goods which are in fashion have greater demand

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compared to those which are not. ‘Demonstration effect’ plays an important role in determining the demand
for a product. Demonstration effect refers to a change in demand by seeing another person use a particular
product or commodity.
Example: People now prefer to buy LED’s, when they want to buy TV.

Age factor: The age composition, for instance, plays a vital role in determining demand. Generally, a country
with higher youth population spends more and saves lesser than a country with a greater population of the
old. On the other hand, if the population of a country has more number falling under young age (below 14),
then demand for toys, baby food, nursery, etc. increases.

Other Factors:
These factors effect the market demand for a commodity. These are:

Size of population: Size of the population of a country is an important determinant of market demand. For
instance, larger the population more will be the demand for certain goods like food grains, and pulses etc.
When the number of consumers increases, there will be greater demand for goods.

Distribution of income: Distribution of income affects consumption pattern and hence, the demand for
various goods. The wealth of a country may be so distributed that there are a few very rich people while the
majority are very poor. Then under such scenario propensity to consume of the country will be relatively less,
for the propensity to consume of the rich people is less than that of the poor people. Consequently, the
demand for consumer goods will be comparatively less. If the distribution of income is more equal, then the
propensity to consume of the country as a whole will be relatively high indicating higher demand for goods.

Demographic structure of the market: If the market consists of a large proportion of children, demand
for toys, baby food, etc. increases. On the other hand, if the population consist of old people, demand for
walking sticks, and reading glasses would be high.

Innovation: When there is a change in the technology people generally prefer new version than the old one.
So, change in the technology changes the demand for a product.

Change in money supply: When money supply in the country increases it in turn increases the demand
for goods. On the other hand, when the money supply decreases demand also comes down.
Season or climatic condition: Seasonal goods like umbrella. Raincoat will be more demanded in the rainy
season than any other season.

Note- A change in price brings a movement along the demand curve. Whereas a change in other factors
brings about a shift in the demand curve.

Demand Function: The demand for any commodity mainly depends on the price of that commodity. The
other determinants include price of related commodities, the income of consumers, tastes and preferences of
consumers, and the distribution of income in the country. Hence, the demand function can be written as:

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Dx = f (Px , Pr , Y, T, Yd) , where

Dx = demand for good X
Px = price of good X
Ps = price of related goods
Y = income
T = tastes and preferences of the consumers

Law of Demand: The law of demand is one of the most important laws of economic theory. According to
law of demand, other things being equal, if the price of a commodity falls, the quantity demanded of it will
rise and if the price of a commodity rises, its quantity demanded will decline. Thus, there is an inverse
relationship between price and quantity demanded, other things being same.

Assumptions of the law:

- No change in the consumer’s income
- No change in consumer’s tastes and preferences
- No changes in the prices of other goods
- No new substitutes for the goods have been discovered
- Consumers have perfect knowledge of the market
- Consumers are rational human beings

Thus, the constancy of these other factors is an important assumption of the law of demand.
Demand schedule: A tabular representation of the relationship between price and quantity demanded is
known as the demand schedule. A demand schedule is drawn upon the assumption that all the other
influences remain unchanged. It thus attempts to isolate the influence exerted by the price of the good upon
the amount sold. Demand schedule may be of two types: individual demand schedule and market
demand schedule.

Individual demand schedule: It shows the quantity of the commodities that a consumer will buy at a
selected price. We can take a hypothetical data of an individual consumer for a list of prices and the
corresponding quantities demanded of commodity X. It is also called household demand.
Price (Rs.) Quantity (Units)
50 2
45 3
30 7
25 12
20 18

When price of commodity X is Rs 50 per unit, a consumer purchases 2 units of the commodity.

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When the price falls to Rs 45, he purchases 3 units of the commodity. Similarly, when the price further falls,
the quantity demanded by him goes on rising until at price Rs 20, the quantity demanded by him rises to 18
units. The above table depicts an inverse relationship between price and quantity demanded; as the price of
the commodity X goes on falling, its demand goes on rising.

Demand curve: We can now plot the data from Table on

a graph with price on the vertical axis and quantity on the
horizontal axis. In the figure, we have shown such a graph
and plotted the five points corresponding to each price-
quantity combination shown in Table. We now connect
these points. The curve is called the demand curve for
commodity ‘X’. The curve shows the quantity of ‘X’ that a
consumer would like to buy at each price; its downward
slope indicates that the quantity of ‘X’ demanded increases
as its price falls.

Market Demand Schedule: When we add up the various quantities demanded by the number of
consumers in the market we can obtain the market demand schedule. Suppose there are three individual
buyers of the goods in the market. The Table shows their individual demands at various prices.

Note: In the above table we are able to notice that as price decreases new buyers join the market.

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Market Demand Curve: If we plot the market

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

Reasons for downward slope of demand curve: Why does demand curve slope downwards?
Different economists have given different explanations for the operation of law of demand.
These are given below.
1) Law of diminishing marginal utility: According to Marshall, people will buy more quantity at lower
price because they want to equalize the marginal utility of the commodity and its price. If the consumer
is at MUx = Px and the price falls then the equation would change to MUx > Px, thus in such a scenario
the consumer has to purchase more units of a commodity in order to reach MUx = Px. He is induced to
buy additional units in order to maximize his satisfaction or utility. The diminishing marginal utility and
equalizing it with the price is the cause for the downward sloping demand curve.
2) Income effect: When the price of a commodity falls, the consumer can buy the same quantity of the
commodity with lesser money or he can buy more of the same commodity with the same amount of
money. In other words, as a result of fall in the price of the commodity, consumer’s real income or
purchasing power increases. This increase in the real income induces him to buy more units of that
commodity. Thus, quantity demanded for that commodity (whose price has fallen) increases. This is
called income effect.
3) Substitution effect: Hicks and Allen have explained the law in terms of substitution effect and income
effect. When the price of a commodity falls, it becomes relatively cheaper than other commodities. It
induces consumers to substitute the commodity whose price has fallen as against other commodities
(substitute commodity) which have now become relatively expensive. The result is that the total quantity
demanded for the commodity whose price has fallen increases (commodity in question). This is called
substitution effect.

PRICE EFFECT = INCOME EFFECT + SUBSTITUTION EFFECT

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4) Arrival of new consumers: When the price of a commodity falls, more consumers start buying it
because some of those who could not afford to buy it previously may now afford to buy it. This raises the
number of consumers of a commodity at a lower price and hence the quantity demand for the commodity
in question increases.
5) Different uses: Certain commodities have multiple uses. If their prices fall they will be used for varied
purposes and quantity demanded for such commodities will increase. When the price of such
commodities rises they will be put to limited uses only. Thus, different uses of a commodity make the
demand curve slope downwards reacting to changes in price.

Expansion and contraction of demand

Other things being equal the law of demand, show an inverse relationship between price of the commodity
and quantity demanded. If demand for a particular commodity changes as a result of changes in its price
alone, we denote is as expansion and contraction of demand. Thus, we see that expansion or contraction of
demand takes place as a result of changes in price, while all other factors influencing demand remain
constant.
- When the quantity demanded of a good rises due to a fall in price, it is called expansion of demand.
- When the quantity demanded of good decreases due to a rise in price, it is called contraction of demand.

Scenario A Scenario B
Combination Price Quantity Combination Price Quantity
(Y) (X) (Y) (X)
A 80 10 A 60 15
B 70 12 B 70 12

The phenomena of expansion and contraction of demand are shown in the above Figure. The figure which is
based on Scenario A Shows that when price is Rs 80 quantity demanded is 10, given other things equal. As
the price decreases to Rs 70, the quantity demanded increases to 12, we say that there is ‘an increase in
quantity demanded’ or ‘expansion of demand’ or ‘a downward movement on the same demand
curve’.

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Similarly, in Scenario B as a result of increase in price to Rs 70, the quantity demanded falls to 12, we say that
there is ‘contraction of demand’ or ‘a fall in quantity demanded’ or ‘anupward movementon the same demand
curve.’

Increase and decrease in demand

Till now we have assumed that other determinants remain constant when we are analyzing demand for a
commodity. It should be noted that expansion and contraction of demand take place as a result of changes in
the price while all other determinants of Demand viz. income, tastes and price of related goods remain
constant. These other factors remaining constant means that the position of the demand curve remains the
same and the consumer moves downwards or upwards on it.

When all the other factors influencing demand also change, there is an increase or decrease in demand and
the demand curve shifts either to its right or left. If the income of a consumer rises, he would be able to
purchase more number of units of a commodity which he earlier could not afford. This would result in
increase in demand and therefore, the demand curve shifts to the right. If, on the other hand, the goods are
out of fashion, the demand of that good will decline, resulting in the shift of the demand curve to the left.

Demand may also increase and decrease due to the following reasons
Increase in demand - Rise in income
(A shift in the demand curve towards the right) - Rise in the price of substitutes
- Fall in the price of a complement
- Favourable change in taste towards the
commodity
- Increase in population
Decrease in demand - Fall in income
(A shift in the demand curve towards the left) - Fall in the price of substitutes
- Rise in the price of a complement
- Unfavourable change in taste towards the
commodity
- Decrease in population

A rightward shift in the demand curve: When demand changes not because of price but because of
change in other determinants of demand, it is a case of either increase or decrease in demand. “Increase in
demand means more demand at same price”. In case of increase in demand, the demand curve shifts to the
right hand side or shifts away from the origin.

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A leftward shift in the demand curve:

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

Movements along demand curve vs. Shift of curve

It is important in Economics to make a distinction between movements along a demand curve and a shift of
the whole demand curve.

A movement along the demand curve indicates changes in the quantity demanded because of price
changes, other factors remaining constant. A shift of the demand curve indicates that there is a change in
demand at each possible price because one or more other factors, such as income, taste or the price of some
other goods, have changed.

Thus, when an economist speaks of an increase or a decrease in demand, he refers to a shift

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

Exceptions to the Law of Demand

According to the law of demand, more of a commodity will be demanded at lower prices than at higher prices,
other things being equal.

The law of demand is valid in most cases; however there are certain cases where this law does not hold good.
The following are the exceptions to the law of demand.
i) Conspicuous goods: Articles of prestige value or snob appeal or articles of conspicuous consumption
are demanded only by the rich people and these articles become more attractive if their prices go up. Such
articles will not conform to the usual law of demand.

This was found out by Thorsten Veblen in his doctrine of “Conspicuous Consumption” and hence this
effect is called “Veblen effect” or prestige goods effect. Veblen effect takes place as some consumers
measure the utility of a commodity by its price i.e., if the commodity is expensive they think that it has

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got more utility. As such, they buy less of this commodity at low price and more of it at high price.
Diamonds & gold are often given as example of this case.

ii) Giffen goods: Sir Robert Giffen, an economist, was surprised to find out that as the price of bread
increased, the British workers purchased more bread and not less of it. This was something against the
law of demand. Why did this happen? The reason given for this is that when the price of bread went up,
it caused such a large decline in the purchasing power of the poor people that they were forced to cut
down the consumption of meat and other more expensive foods. Since bread, even when its price was
higher than before, was still the cheapest food article, people consumed more of it and not less when its
price went up.Thus, this is a clear exception to the law of demand hence, the demand curve has a positive
slope.
Such goods which exhibit direct price-demand relationship are called ‘Giffen goods’.
For a commodity to qualify as a “giffen good”
a) The goods are inferior goods
b) The goods form a substantial part of consumer’s budget
c) The household is poor with limited income
It is to be understood that all inferior goods do not show such trend as they may not qualify for the other
requisites. Hence all giffen goods are inferior goods but all inferior goods are not necessarily giffen goods.
Examples of giffen goods are coarse grains like bajra, low quality rice and wheat etc.

iii) Conspicuous necessities: The demand for certain goods is affected by the demonstration effect of the
consumption pattern of a social group to which an individual belongs. These goods, due to their constant
usage, have become necessities of life.
Example: Demand for refrigerator, TV sets etc. does not fall even if their price rises. This is because they
have become necessities of life due to continuous usage.

iv) Future expectations about prices: It has been observed that when the prices are rising, households
expecting that the prices in the future will be still higher, tend to buy larger quantities of the commodities.
For example, when people expect that prices of petrol would rise in future. They demand greater
quantities of petrol as their pricesare on a rise.
It is to be noted that here it is not the law of demand which is invalidated but there is a change in one of
the factors which was held constant while deriving the law of demand, namely change in the price
expectations of the people.

v) Imperfect knowledge: The law has been derived assuming consumers to be rational and
knowledgeable about market-conditions. However, at times consumers tend to be irrational and make
impulsive purchases without any rational calculations about price and usefulness of the product and in
such contexts the law of demand fails.

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vi) Emergency: In case of emergency, people will buy the goods no matter how high the prices are.If there is
a scenario of emergency in a country, people will tend to buy goods required even if their prices are high.

vii) Demand for necessaries: The law of demand does not apply much in the case of necessaries of life.
Irrespective of price changes, people have to consume the minimum quantities of necessary
commodities.

viii) Speculative goods: In the speculative market, particularly in the market for stocks and shares, more will
be demanded when the prices are rising and less will be demanded when prices decline.
When there is an exception to the law of demand we would be generally coming up with an upward sloping
demand curve.

Elasticity of Demand
Till now we were concerned with the direction of the changes in prices and quantities demanded.
Now we will try to measure these changes, or to say, we will try to answer the question “by how much”?
The law of demand explains that demand will change due to a change in the price of the commodity. But it
does not explain the rate at which demand changes to a change in price. i.e, Law of Demand explains only the
direction of change but not the magnitude. Hence Law of Demand is only a qualitative statement. Whereas
the concept of ‘elasticity of demand’ measures the rate of change in demand and hence is a quantitative
statement.

The concept of elasticity of demand was introduced by Alfred Marshall. According to him, “the elasticity (or
responsiveness) of demand in a market is great or small according as the amount demanded increases much
or little for a given fall in price, and diminishes much or little for a given rise in price”. Elasticity of Demand
is the “measure of responsiveness or the degree of change in quantity demanded due to changes in one of the
variables on which demand depends – these variables are price of a commodity, price of related commodities
and income of consumers”.

Types of elasticity of demand

Elasticity of demand can be broadly classified under
a) Price elasticity
b) Cross elasticity and
c) Income elasticity.

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It is to be noted that when we talk of elasticity of demand, unless and until otherwise mentioned, we talk of
price elasticity of demand.
In other words, it is price elasticity of demand which is usually referred to as elasticity of demand.

Price Elasticity: Price elasticity of demand expresses the response of quantity demanded of a good to a
change in its price, assuming the consumer’s income, his tastes and prices of all other goods as constant.
Methods of measuring price elasticity of demand
- Percentage method or proportional method or Formula Method.
- Point elasticity method or Geometric Method.
- Are elasticity method
- Total outlay method or Expenditure method

Percentage method or proportional method or formula method: This is measured as percentage change in
quantity demanded divided by the percentage change in price, other things remaining equal. That is

Since price and quantity are inversely related (with a few exceptions) price elasticity is negative. But, for the
sake of convenience, we ignore the negative sign and consider only the numerical value of the elasticity.

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Note: Thus if a 10% change in price leads to 20% change in quantity demanded of good X and 40%
change in quantity demanded of good Y, then we get elasticity of X and Y as 2 and 4 respectively,
showing that demand for Y is more elastic or responsive to price changes than that of X. Had we
considered minus signs (-2 > -4) we would have concluded that the demand for X is more elastic than
that for Y, which is not correct. Hence, by convention, we take the absolute value of price elasticity and
draw conclusions.

Example- if the price of the commodity A is 25 and the quantity demanded is 50. What would be the elasticity
of demand if the price goes up to 30 and quantity demanded goes down to 40?
∆q p
On applying the formula Ep = x
∆p q
10 25
We get- Ep = x = -1
−5 50

Point elasticity or geometric method: It measures elasticity of demand at a particular point on the demand
curve. We can calculate the price elasticity of demand at a point on the linear demand curve. This method is
usually used when the change is extremely small. Formula to find out Ep through point method is
Lower segment of the demand curve from the point
Upper segment of the demand curve from the point
Point elasticity makes use of derivative rather than finite changes in price and quantity. It may be defined as:

Ep =

dq
Where is the derivative of quantity with respect to price at a point
dp
on the demand curve, and p and q are the price and quantity at that
point.
It is to be noted that elasticity is different at different points on the
same demand curve. Given a straight line demand curve DD’, point
elasticity at any point can be found by using the formula. Let us
assume DD’ to be 20cms divided into 4 equal parts of 5cms each. In
the table given below we calculate the elasticity at various points.
Ep at different Point on the demand Ep = lower segment / Price
Sl. No.
curve as seen in the figure above upper segment elasticity
R Ep at point R RD’/RD = 10/10 = 1 Ep = 1
L Ep at point L LD’/LD = 5/15 =0.33 Ep < 1
S Ep at point B SD’/SD = 15/5 = 3 Ep > 1
D’ Ep at point D’(bottom of the demand curve) D’D’/DD’ = 0/20 = 0 Ep = 0
D Ep at point D (top of the demand curve) DD’/DD = 20/0 = ∞ Ep = ∞

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Arc-elasticity: When the price change is somewhat larger or when price elasticity is to be found
between two points on the demand curve, the question arises which price and quantity should be taken
as base. This is because elasticities found by using original price and quantity figures as base will be different
from the one derived by using new price and quantity figures. Therefore, in order to avoid confusion,
generally midpoint method is used i.e. averages of the two prices and quantities are taken as
(i.e. original and new) base. The arc elasticity can be found out by using the formula:
𝐪𝟏 − 𝐪𝟐 𝐩𝟏 + 𝐩𝟐
Ep = x
𝐩𝟏 − 𝐩𝟐 𝐪𝟏 + 𝐪𝟐

Where,
q1 = original quantity
q2 = new quantity
p1 = original price
p2 = new price

Note: If the problem is silent about the method to calculate price elasticity, then Arc method should be
used.

Example: where p1, q1 are the original price and quantity and p2, q2 are the new ones.
Thus, if we have to find elasticity of cricket bat between:
p1= Rs 500 q1 = 100
p2 = Rs 400 q2 = 150
q1 − q2 p1 + p2
So, by using the formula, Ep = x
p1 − p2 q1 + q2
𝟏𝟎𝟎−𝟏𝟓𝟎 𝟓𝟎𝟎+𝟒𝟎𝟎
Ep= x
𝟓𝟎𝟎−𝟒𝟎𝟎 𝟏𝟎𝟎+𝟏𝟓𝟎
−𝟓𝟎 𝟗𝟎𝟎
Ep= x
𝟏𝟎𝟎 𝟐𝟓𝟎

Ep= -1.8

Total outlay method: This method is also known as Total Expenditure method. We can measure elasticity
though a change in expenditure on commodities due to change in price. This method provides only the
direction of elasticity rather than the exact extent of elasticity. We can only know whether elasticity is equal
to, greater than or less than 1. Formula for this method is
TE= P X Q
Types of elasticity of demand
Changes in price
ep = 1 ep < 1 ep > 1
Fall in price Total outlay remains constant Total outlay falls Total outlay rises
Rise in price Total outlay remains constant Total outlay rises Total outlay falls

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Example:-
Price of X (P) (Rs.) Quantity demanded Total outlay (PxQ) Elasticity of demand (e)
(Q)
10 2,000 20,000
8 3,000 24,000 > 1 Relatively elastic
4 7,000 28,000

Price of Y (P) (Rs.) Quantity demanded Total outlay (PxQ) Elasticity of demand (e)
(Q)
20 2,000 40,000
16 2,500 40,000 = 1 Unitary Elastic
8 5,000 40,000

Price of Z (P) (Rs.) Quantity demanded Total outlay (PxQ) Elasticity of demand (e)
(Q)
15 2,000 30,000
12 2,250 27,000 <1 Relatively inelastic
10 2,500 25,000

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

Interpretation of Numerical Values of Elasticity of Demand

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

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Perfectly inelastic: In this case, whatever may be the change in price

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

Unitary elastic: Any change in price brings about an equally

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

Relatively elastic: In this case a slight change in price leads to

more than proportionate change in quantity demanded. This can be
represented by a gradually sloping demand curve (it will be flatter).
The numerical co-efficient of relatively elastic demand is > 1. In this
case the demand curve would be flatter or wider. This holds good in
case of luxuries.
Relatively inelastic: In this case, a large change in price leads to
less proportionate change in demand. This can be represented by a
steeply sloping demand curve. The numerical co-efficient or
relatively inelastic demand is < 1. This condition holds goods in case
of necessaries.
In the given diagram we notice as the price moves from P1 to P2 the
quantity decreases from Q1 to Q2.

Numerical measure of elasticity Description Terminology

Zero Quantity demanded does not change as Perfectly inelastic
price changes
Greater than zero, but less than one Quantity demanded changes by a Relatively Inelastic
smaller percentage than change in price
One Quantity demanded changes by exactly Unit elasticity
the same percentage as change in price

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Greater than one, but less than infinity Quantity demanded changes by a larger Relatively Elastic
percentage than change in price
Infinity Buyers are prepared to buy all they can Perfectly elastic
obtain at some price and none at all at
an even slightly higher price
Determinants of Price Elasticity of Demand
Now an important question is: what are the factors which determine whether the demand for a good is elastic
or inelastic? We will consider the following important determinants of price elasticity.

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

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

Income elasticity of demand

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

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It can be represented as:

% 𝑐ℎ𝑎𝑔𝑛𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
Price Elasticity = Ey = % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒
Or
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
𝑥 100
Ey = 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒
𝑥 100
𝑂𝑟𝑖𝑛𝑔𝑖𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒
Or
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒
Ey= 𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 x 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒

Or in symbolic terms
Δ𝑞 Y Δ𝑞 Y
Ey = x = x
𝑞 Δ𝑌 Δ𝑌 q
Ey = Income elasticity of demand
∆𝑞 = Change in demand
q = Original demand
Y = Original money income
∆𝑌 = Change in money income

Interpretation of income elasticity.

Elasticity greater than one (Ey> 1): If income levels increase, and the demand for certain goods increase
by more than proportionate extent. If the income elasticity for a good is greater than one, it shows that the
commodity forms a larger part of consumer’s expenditure as he becomes richer. Such goods are called luxury
goods. The income elasticity is greater than unity.

Elasticity equal to one (Ey = 1): If the proportion of income spent on goods remains the same as income
increases, then the income elasticity is equal to one. It provides a useful dividing line which helps to divide
luxuries and necessities.
Elasticity lesser than one (>0 Ey< 1): If income levels increases, and the demand for goods increase by
less than proportionate extent, such goods will be necessary goods. The income elasticity is lesser than unity
in case of necessities.
Elasticity lesser than zero (Ey< 0): If demand decreases with an increase in money income of consumers,
such goods are called inferior goods. As the consumer has more money income than before he would
substitute superior commodity in place of inferior one. The income elasticity is lesser than zero.
In other words,

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- In case of inferior goods, income elasticity is < 0.

- In case of necessary goods, income elasticity is > 0 but <1
- In case of luxury goods, income elasticity is >1.
The following examples will make the above concepts clear:
a) The income of a household rises by 20%, the demand for Rice increases by 10%.
b) The income of a household rises by 10%, the demand for Refrigerator rises by 20%.
c) The incomes of a household rises by 10%, the demand for Jowar falls by 5%.
d) The income of a household rises by 10%, the demand for shirt rises by 10%.
e) The income of a household rises by 15%, the demand for salt does not change at all.
Serial Commodity Income Interpretation
number elasticity
A Rice 10%
= 0.5 (ey<1) as the income elasticity is less than 1the
20%
commodity in question isnormal goods and
fulfills the criteria of necessaries.
B Refrigerator 15%
= 1.5 (ey>1) as the income elasticity is more than 1the
10%
commodity in question isa luxury.
C Jowar −5%
= -0.5 (ey<0) as the income elasticity is negative(less than
10%
0)the commodity in question is inferior
commodity.
D Shirt 10%
= 1 (ey=1) the income elasticity of the commodity is
10%
unitary.
E Salt 0%
=0 (ey=0) the income elasticity of the commodity is 0.
15%

Note-In case of shirt the elasticity is 1 and they can be construed as normal goods. On the other hand elasticity
of salt is 0 which denote that it is an essential commodity and the consumer avoids altering its consumption
with a change in his income.

Cross elasticity of demand:

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

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Cross elasticity of demand (Exy) can be computed as follows:-

% 𝑐ℎ𝑎𝑔𝑛𝑒 𝑖𝑛 𝑑𝑒𝑚𝑎𝑛𝑑 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑋

Exy = % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦

Or
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥
𝑋 100
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥
Exy = 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑦
𝑋 100
𝑂𝑟𝑖𝑛𝑔𝑖𝑎𝑙 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑦

Symbolically the formula can be represented as:-

Δ𝑞𝑥 𝑝𝑦
Exy= 𝑞𝑥
x Δ𝑝
𝑦

Δ𝑞 𝑝𝑦
Exy = Δ𝑝𝑥 x 𝑞
𝑦 𝑥

Exy stands for cross elasticity

qx stands for original quantity demanded of X
∆qx stands for change in quantity demanded of X
py stands for the original price of good Y
∆py stands for a small change in the price of Y

Substitute Products:-In case of the substitute products,

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

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Complementary Goods:-In the case of complementary

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

Interpretation of cross elasticity.

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

Demand classification are as follows

Producer’s goods and consumers goods: Producer’s goods are those which are used for the production
of other goods- either consumer goods or producer goods. e.g. Plant, Machines etc. The goods which are used
for a final consumption are called consumer’s goods. e.g. Food articles, Watches etc.

Durable and non durable (perishable) goods: Consumer’s goods may be further sub-divided into
durable and non-durable goods. The goods which are durable in nature i.e. can be consumed more than once,
like watches, TV etc. The goods which are perishable in nature are called Non durable goods. Ex: these goods
cannot be consumed more than once and also cannot be stored for long time, like food items.

Derived and autonomous demand: If the demand for the good is derived from the demand of other
parent good it is called derived demand. e.g. demand for cement is derived from demand for buildings. If the
demand for a product is independent of the demand for other goods, then it is called autonomous demand
e.g. food. This distinction is purely arbitrary and it is very difficult to find out which product is entirely
independent of other products.

Industry demand and company demand: An industry is an aggregate of firms. Industry demand means
it’s an aggregate demand of the companies of a particular industry. e.g. FMCG Industry. The company
demand is the demand of an individual company or firm.

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Short run and long run demand: Short run demand immediate response of demand if there is a change
in price, income etc. whereas long-run demand is that which will ultimately exist as a result of changes in
pricing, promotion or product improvement, after enough time is allowed to let the market adjust to the new
situation.

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

Demand Forecasting:
Forecasting, in general, refers to knowing or measuring the status or nature of an event or variable before it
occurs. Forecasting of demand is the art and science of predicting the probable demand for a product or a
service at some future date on the basis of certain past behaviour patterns of some related events and the
prevailing trends in the present. It should be kept in mind that demand forecasting is no simple guessing, but
it refers to estimating demand scientifically and objectively on the basis of certain facts and events relevant
to forecasting.

Usefulness
The significance of demand or sales forecasting in the context of business policy decisions can hardly be over
emphasized. The effectiveness of the plans of business managers depends upon the level of accuracy with
which future events can be predicted. Forecasting of demand plays a vital role in the process of planning and
decision-making, whether at the national level or at the level of a firm. The importance of demand forecasting
has increased all the more on account of mass production and production in response to demand. A good
forecast enables the firm to perform efficient business planning. Forecasts offer information for budgetary
planning and cost control in functional areas of finance and accounting. Good forecasts help in efficient
production planning, process selection, capacity planning, facility layout and inventory management. A firm
can plan production scheduling well in advance and obtain all necessary resources for production such as
inputs, and finances. Capital investments can be aligned to demand expectations and this will check the
possibility of overproduction and underproduction, excess of unused capacity and idle resources. Marketing
relies on sales forecasting in making key decisions. Demand forecasts also provide the necessary information
for formulation of suitable pricing and advertisement strategies.

It is said that no forecast is completely fool-proof and correct. However, the very process of forecasting helps
in evaluating various forces which affect demand and is in itself a reward because it enables the forecasting
authority to know about various forces relevant to the study of demand behaviour.

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Scope of Forecasting
Demand forecasting can be at the international level depending upon the area of operation of the given
economic institution. It can also be confined to a given product or service supplied by a small firm in a local
area. The scope of the forecasting task will depend upon the area of operation of the firm in the present as
well as what is proposed in future. Much would depend upon the cost and time involved in relation to the
benefit of the information acquired through the study of demand. The necessary trade-off has to be struck
between the cost of forecasting and the benefits flowing from such forecasting.

Types of forecasts
1) Macro-level forecasting deals with the general economic environment prevailing in the economy as
measured by the Index of Industrial Production (IIP), national income and general level of employment
etc.
i) Industry- level forecasting is concerned with the demand for the industry’s products as a whole. For
example, demand for cement in India.
ii) Firm- level forecasting refers to forecasting the demand for a particular firm’s product, say, the
demand for ACC cement.

2) Based on time period, demand forecasts may be short-term demand forecasting and long-term demand
forecasting.
i) Short-term demand forecasting covers a short span of time, depending of the nature of industry. It is
done usually for six months or less than one year and is generally useful in tactical decisions.
ii) Long-term forecasts are for longer periods of time, say two to five years and more. It provides
information for major strategic decisions of the firm such as expansion of plant capacity.

Methods of demand Forecasting

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

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

Although this method is simple and based on first hand information of those who are directly connected
with sales, it is subjective as personal opinions can possibly influence the forecast. Moreover salesmen
may be unaware of the broader economic changes which may have profound impact on future demand.
Therefore, forecasting could be useful in the short run, for long run analysis however, a better technique
is to be applied.

iii) Expert Opinion method: In general, professional market experts and consultants have specialised
knowledge about the numerous variables that affect demand. This, coupled with their varied experience,
enables them to provide reasonably reliable estimates of probable demand in future. Information is
elicited from them through appropriately structured unbiased tools of data collection such as interviews
and questionnaires.

The Delphi technique, developed by Olaf Helmer at the Rand Corporation of the USA, provides a useful
way to obtain informed judgments from diverse experts by avoiding the disadvantages of conventional

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panel meetings. Under this method, instead of depending upon the opinions of buyers and salesmen,
firms solicit the opinion of specialists or experts through a series of carefully designed questionnaires.
Experts are asked to provide forecasts and reasons for their forecasts. Experts are provided with
information and opinion feedbacks of others at different rounds without revealing the identity of the
opinion provider. These opinions are then exchanged among the various experts and the process goes
on until convergence of opinions is arrived at. This method is best suited in circumstances where
intractable changes are occurring and the relevant knowledge is distributed among experts. Delphi
technique is widely accepted due to its broader applicability and ability to address complex questions. It
also has the advantages of speed and cheapness.

iv) Statistical methods: Statistical methods have proved to be very useful in forecasting demand.
Forecasts using statistical methods are considered as superior methods because they are more scientific,
reliable and free from subjectivity. The important statistical methods of demand forecasting are:
a) Trend Projection method: This method, also known classical method, is considered as a ‘naive’
approach to demand forecasting. A firm which has been in existence for a reasonably long time would
have accumulated considerable data on sales pertaining to different time periods. Such data, when
arranged chronologically, yield a ‘time series’. The time series relating to sales represent the past
pattern of effective demand for a particular product. Such data can be used to project the trend of the
time series. The trend projection method assumes that factors responsible for the past trend in
demand will continue to operate in the same manner and to the same extent as they did in the past in
determining the magnitude and direction of demand in future. The popular techniques of trend
projection based on time series data are;
a) graphical method and
b) Fitting trend equation or least square method.
b) Graphical Method: This method, also known as ‘free hand projection method’ is the simplest and
least expensive. This involves plotting of the time series data on a graph paper and fitting a free- hand
curve to it passing through as many points as possible. The direction of the curve shows the trend.
This curve is extended into the future for deriving the forecasts. The direction of this free hand curve
shows the trend. The main draw-back of this method is that it may show the trend but the projections
made through this method are not very reliable.
c) Fitting trend equation: Least Square Method: It is a mathematical procedure for fitting a line to a
set of observed data points in such a manner that the sum of the squared differences between the
calculated and observed value is minimised. This technique is used to find a trend line which best fit
the available data. This trend is then used to project the dependant variable in the future. This method
is very popular because it is simple and inexpensive. Moreover, the trend method provides fairly
reliable estimates of future demand.

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The least square method is based on the assumption that the past rate of change of the variable under
study will continue in the future. The forecast based on this method may be considered reliable only
for the period during which this assumption holds. The major limitation of this method is that it
cannot be used where trend is cyclical with sharp turning points of troughs and peaks. Also, this
method cannot be used for short term forecasts.
d) Regression analysis: This is the most popular method of forecasting demand. Under this method, a
relationship is established between the quantity demanded (dependent variable) and the independent
variables (explanatory variables) such as income, price of the good, prices of related goods etc. Once
the relationship is established, we derive regression equation assuming the relationship to be linear.
The equation will be of the form Y = a + bX. There could also be a curvilinear relationship between
the dependent and independent variables. Once the regression equation is derived, the value of Y i.e.
quantity demanded can be estimated for any given value of X.

v) Controlled Experiments: Under this method, future demand is estimated by conducting market
studies and experiments on consumer behaviour under actual, though controlled, market conditions. This
method is also known as market experiment method. An effort is made to vary separately certain
determinants of demand which can be manipulated, for example, price, advertising, etc., and conduct the
experiments assuming that the other factors would remain constant. Thus, the effect of demand
determinants like price, advertisement, packaging, etc., on sales can be assessed by either varying them
over different markets or by varying them over different time periods in the same market. The responses
of demand to such changes over a period of time are recorded and are used for assessing the future
demand for the product. For example, different prices would be associated with different sales and on
that basis the price-quantity relationship is estimated in the form of regression equation and used for
forecasting purposes. It should be noted however, that the market divisions here must be homogeneous
with regard to income, tastes, etc.

The method of controlled experiments is used relatively less because this method of demand forecasting
is expensive as well as time consuming. Moreover, controlled experiments are risky too because they
may lead to unfavourable reactions from dealers, consumers and competitors. It is also difficult to
determine what conditions should be taken as constant and what factors should be regarded as variable
so as to segregate and measure their influence on demand. Besides, it is practically difficult to satisfy the
condition of homogeneity of markets.

Market experiments can also be replaced by ‘controlled laboratory experiments’ or ‘consumer clinics’
under which consumers are given a specified sum of money and asked to spend in a store on goods with
varying prices, packages, displays etc. The responses of the consumers are studied and used for demand
forecasting.

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vi) Barometric method of forecasting: The various methods suggested till now are related with the
product concerned. These methods are based on past experience and try to project the past into the
future. Such projection is not effective where there are economic ups and downs. As mentioned above,
the projection of trend cannot indicate the turning point from slump to recovery or from boom to
recession. Therefore, in order to find out these turning points, it is necessary to find out the general
behaviour of the economy. Just as meteorologists use the barometer to forecast weather, the economists
use economic indicators to forecast trends in business activities. This information is then used to forecast
demand prospects of a product, though not the actual quantity demanded. For this purpose, an index of
relevant economic indicators is constructed. Movements in these indicators are used as basis for
forecasting the likely economic environment in the near future. There are leading indicators,
coincidental indicators and lagging indicators. The leading indicators move up or down ahead of some
other series. For example, the heavy advance orders for capital goods give an advance indication of
economic prosperity. The lagging indicators follow a change after some time lag. The heavy household
electrical connections confirm the fact that heavy construction work was undertaken during the past with
a lag of some time. The coincidental indicators, however, move up and down simultaneously with the
level of economic activities. For example, rate of unemployment.
Theory of supply
Introduction
The term ‘supply’ refers to the amount of a good or service that the producers are willing and able to offer to
the market at various prices over a period of time. Supply is different from stock. Stock is the total quantity
of goods, which is stored in the warehouse, but it may not be offered for sale. Hence supply is only a part of
the stock, which is offered for sale. The concept of supply should be studied from the manufacturer point of
view.

Important points to understand concept of supply:

i) Supply refers to what firms offer for sale, not necessarily to what they succeed in selling.
What is offered may not get sold.
ii) Supply is a flow concept. The quantity supplied is ‘so much’ per unit of time, per day, per week, or per
year.
iii) A given quantity is offered by sellers at a given price, hence the quantity offered by producers offer for
sale changes with the change in the price of that commodity.

Determinants of supply
Price of the commodity: If the price of a commodity increases, quantity supplied will increase and if the
price of a commodity decreases, the quantity supplied will also decrease. This is because goods and services
are produced by the firm in order to earn profits and profits rise with the rise in the price of the product
subject to other things remaining constant.

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Price of the related goods: If the price of other goods rise, they become relatively more profitable to the
firm to produce and sell, than the good in question. If a farmer is producing radish as well as carrot which are
being sold at the same price then it implies, that if the price of carrot rises, the farmer may deploy more of his
land to carrot production and go away from producing radish.

Factors of production: If the cost of factors of production increase then the cost of making goods increases
and may affect the profitability. Hence the price of factors of production plays an important role in the supply
of a commodity.

Technology: Inventions and innovations tend to make it possible to produce more or better goods with the
same resources and tend to increase the supply of some products and to reduce the supply of products that
the displaced.

Government policy: Production of goods may be subject to the imposition of commodity taxes such as
excise duty, sales tax and import duties. These increase the cost of production and so the supply of a
commodity would decrease subject to the prices being stable. Subsidies, on the other hand, reduce the cost of
production and thus provide an incentive to the firm to increase supply.
Goals of the firm: If the firm aims at profit maximization then it would supply less in order to charge higher
prices of its commodity. On the other hand if the firm is attempting to maximize sales and increase market
coverage then the firm would increase supply.

Market structure: If the firm is operating in a perfect competition market then it would supply what ever
it can and on the other hand if the firm is operating under monopoly market then it would constrain its supply.

Supply function
Supply function is a mathematical relationship between supply of a commodity and its determinants.
Sx = f (Ps, Pr, T, C, Ex, Gp)
Where,
Sx = Supply of commodity X
Px = Price of commodity X
Pr = Price of related goods, Y
T = state of technology
C = Cost of production
Ex = Expected price of commodity X
Gp = Government policy

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Law of Supply
The law of supply explains the functional relationship between price of a commodity and its quantity supplied.
It states that: Other things being equal (ceteris paribus), the quantity of a good produced and offered for sale
will increase as the price of the good rises and decrease as the price falls.
Assumptions of the law of the supply:
The law of supply holds good provided:
- Price of the related goods is not changed.
- No change in technology
- Cost of production to be constant
- Government policy should remain same
Supply schedule
A tabular representation of the relationship between price and quantity supplied is known as the supply
schedule. With the help of the supply schedule, a supply curve can be drawn. A supply curve is a graphical
representation of the supply schedule.
There are two types of supply schedule:
- Individual supply schedule
- Market supply schedule

Individual supply schedule: Individual supply schedule is a list of the prices and quantities of a given
commodity offered for sale by an individual seller or producer. The following is an individual supply schedule.
It shows that as the price goes up, an individual seller increases the quantity supplied in the market.
Combination Price of Shirt (Rs.) Quantity of Shirt (Units of good)
A 100 200
B 200 400
C 300 600
D 400 800
E 500 1000

The table shows the quantities of shirt that would be produced and offered for sale by a supplier at a number
of alternative prices. At combination A, for example, 200 units of shirts are offered for sale at Rs 100 per
shirt. Moreover at combination C, for example, 600 units of shirts are offered for sale at Rs 300 per shirt.

Individual supply curve

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

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

Market supply schedule

By adding up the quantity supplied at various prices by all the sellers in the market, we can get the market
supply schedule. Market schedule is the lateral summation of the individual supply schedules of all the
suppliers in the market. The table given below depicts various quantities of a given commodity that the
various producers are ready to produce and offer for sale at different prices. The last column is the summation
of the first three denoting the market supply schedule.

Price Supplier Supplier Supplier z Market

x y Supply
10 - - 20 20
20 - 10 30 40
30 - 20 40 60
40 10 30 50 90
50 20 40 60 120
60 30 50 70 150
70 40 60 80 180
80 50 70 90 210
90 60 80 100 240
100 70 90 110 270

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Market supply curve

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

Reasons for upward slope of the supply curve

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

b) Increasing marginal cost: The producer in order to produce more units of a commodity has to
increase the quantity of variable factors which entails higher cost. So, in order to cover the increased
costs producer have to supply at higher prices.

c) More number of suppliers: As the price of a commodity increases more number of suppliers
would join thereby leading to increase in quantity of goods supplied.

Expansion or contraction of supply:

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

Earlier price was OP1 and quantity supplied was OQ1. When price
increases to OP2, quantity supplied also increases to OQ 2, similarly
when price decreases to OP3 supplied also decreases to OQ3.
Expansion and contraction refers to an increase or decrease in the
quantity supplied respectively. Hence it is called as movement on the
supply curve.

SHIFTS IN SUPPLY CURVE – INCREASE OR DECREASE IN SUPPLY

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

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Increase in supply - Fall in the price of substitutes

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

Difference between movement and shift in supply curve.

Basis of difference Movement along the curve Shift of the curve
Meaning It takes place as a result of It takes place due to changes in
change in price, other things factors other than price, i.e. price
remains constant. It is also remains constant. It is also known as
known as a change in quantity a change in supply
supplied
Supply curve Supply curve remains the same Supply curve shifts either to the
right or to the left
Terminology Expansion and contraction of Increase and decrease in supply
Supply

ELASTICITY OF SUPPLY
The elasticity of supply is defined as the responsiveness of the quantity supplied of a good to a change in its
price. Law of supply is a qualitative statement on the other hand elasticity of supply is a quantitative
statement.

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There are three ways of computing of elasticity of supply.

1) Percentage method
2) Arc method
3) Point method / Geometric method

Percentage method

% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑

Es = % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒

or
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑
𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑
Es = 𝑐ℎ𝑛𝑎𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
𝑃𝑟𝑖𝑐𝑒

Symbolically-
∆𝑞
𝑞 ∆𝑞 𝑝
Es= ∆𝑝 = ∆𝑝 x 𝑞
𝑝

Where,
q = denotes original quantity supplied
∆q = Change n quantity supplied
p = Original price
∆p = Change in price
Note: As per the law of supply, there is a direct relationship between price and quantity supplied.
So, price elasticity of supply is positive.

Example:

Quantity (units) Price (Rs.)

50 100
80 150

∆q
q ∆q p
Applying the formula:-Es = ∆p = x
∆p q
p

−30 100
= x
−50 150

= 0.40

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Point elasticity: The elasticity of supply can be considered with reference to a given point on the supply
curve or between two points on the supply curve.
When elasticity is measured at a given point on the supply curve, it is called point elasticity.
Point-elasticity of supply can be measured with the help of the following formula:

Es =

dq
Where is the derivative of quantity with respect to price at a point on the supply curve, and p and q are
dp
the price and quantity at that point.
Where,
p = Price
q = Quantity
∆p = Change in price
∆q = Change in quantity
Example: The Supply function is given as q = -200 + 20p. Find the elasticity of supply using point method,
when price is Rs 30.
Applying the formula

Es =

= 20, P = 30
At price 40 the quantity supplied would be q = -200 + 20 (30)
q = 400
Es = 20 x 30/400
Es = 1.5
Arc-elasticity:When the price change is somewhat larger or when price elasticity is to be found
between two points on the supply curve, the question arises which price and quantity should be taken
as base. This is because elasticities found by using original price and quantity figures as base will be different
from the one derived by using new price and quantity figures. Therefore, in order to avoid confusion,
generally midpoint method is used i.e. averages of the two prices and quantities are taken as
(i.e. original and new) base. The arc elasticity can be found out by using the formula:
𝐪𝟏 − 𝐪𝟐 𝐩𝟏 + 𝐩𝟐
Es = x
𝐩𝟏 − 𝐩𝟐 𝐪𝟏 + 𝐪𝟐

Where,
P1 = original price
P2 = new price
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q1 = original quantity
q2 = new quantity
Quantity (units) Price (Rs.)
250 100
280 120
Applying the formula
𝐪𝟏 − 𝐪𝟐 𝐩𝟏 + 𝐩𝟐
Es = x
𝐩𝟏 − 𝐩𝟐 𝐪𝟏 + 𝐪𝟐

We get
= 30 / 20 x (100 + 120) / (250 + 280)
= 0.6

Types and Interpretation of elasticity of supply

i) Perfectly inelastic supply: If as a result of a change in
price, the quantity supplied of a good remains unchanged,
we say that the elasticity of supply is zero or the good has
perfectly inelastic supply. In the diagram as the price
increases from Rs 2 to Rs 4 the quantity supplied remains 4
units.
Thus we notice that the quantity supplied of the commodity
does not change with a change in price. Thus the elasticity of
supply is 0.
ii) Perfectly elastic supply: Elasticity of supply said to be
infinite when nothing is supplied at a lower price but a small
increase in price causes supply to rise from zero to a large
amount indicating that producers will supply large quantity
demanded at that price. This leads to a supply curve which
is parallel to X axis indicating infinite elasticity of supply.

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iii) Relatively less-elastic supply: If as a result of a change

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

iv) Relatively elastic supply: If elasticity of supply is greater

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

v) Unitary elasticity: If the relative change in the quantity

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

DETERMINANTS OF ELASTICITY OF SUPPLY

a) Behavior of cost of production:- elasticity of supply depends on the change in the cost of production
upon producing addition quantity of output. If the cost decreases or remains stable on producing an
additional unit of output then the supply increases (elastic) on the other hand if the cost of producing an
addintional unit increases then the supply would not increase (inelastic).
b) Time element:- supply tends to relatively inelastic in the short run. However in the long run the supply
is elastic as new plants can be set up and production capacity can be expanded.

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c) Nature of commodity:- supply of perishable goods tend to be less elastic as products cannot be stored
on the other hand supply of durable goods tends to be relatively elastic as they can be stored.
d) Availability of facilities for expanding output:- if producers have sufficient production facilities,
they would be able to increase their supply and therefore the supply would be relatively elastic. On the
other hand if the shortage of power, fuel or raw materials, the output would expand slowly thus being
inelastic.
e) Expectations regarding future prices:- if the producers expect the rise in the prices of the
commodity then the supply of the commodity in the present would be less elastic and vice-versa.

EQUILIBRIUM

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

The equilibrium between demand and supply is depicted in the diagram below. Demand and Supply are in
equilibrium at point E where the two curves intersect each other. It means that only at price ` 3 the quantity
demanded is equal to the quantity supplied. The equilibrium quantity is 19 units and these are exchanged at
price ` 3.

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CHANGES IN DEMAND AND SUPPLY

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

i) An increase in demand: In figure 2, the original demand

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

Decrease in Demand: The opposite will happen when

demand falls as a result of a fall in income, while the supply
remains the same. The demand curve will shift to the left and
become D1D1 while the supply curve remains as it is. With the
new demand curve D1D1, at original price OP, OQ2 is demanded
and OQ is supplied. As the supply exceeds demand, price will
come down and quantity demanded will go up. A new
equilibrium price OP1 will be settled in the market where
demand OQ1 will be equal to supply OQ1.
Thus, with a decrease in demand, there is a decrease in the equilibrium price and quantity demanded and
supplied.

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Increase in Supply: Let us now assume that demand does not

change, but there is an increase in supply say, because of
improved technology.
The supply curve SS will shift to the right and become S1S1. At
the original equilibrium price OP, OQ is demanded and OQ2 is
supplied (with new supply curve). Since the supply is greater
than the demand, the equilibrium price will go down and
become OP1 at which OQ1 will be demanded and supplied.
Thus, as a result of an increase in supply with demand
remaining the same, the equilibrium price will go down and the quantity demanded will go up.

Decrease in Supply: If because of some reason, there is a decrease

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

SIMULTANEOUS CHANGES IN DEMAND AND SUPPLY

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

Fig. 6: Simultaneous Change in Demand and Supply

Fig. 6 shows simultaneous change in demand and supply and its effects on the equilibrium price. In the figure,
the original demand curve DD and the supply curve SS meet at E at which OP is the equilibrium price and
OQ is the quantity bought and sold.

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Fig. 6 (a), shows that increase in demand is equal to increase in supply. The new demand curve D1D1 and
S1S1 meet at E1. The new equilibrium price is equal to the old equilibrium price (OP).

Fig. 6 (b), shows that increase in demand is more than increase in supply. Hence, the new equilibrium price
OP1 is higher than the old equilibrium price OP. The opposite will happen i.e. the equilibrium price will go
down if there is a simultaneous fall in demand and supply and the fall in demand is more than the fall in
supply.
Fig. 6 (c), shows that supply increases in a greater proportion than demand. The new equilibrium price will
be less than the original equilibrium price. Conversely, if the fall in the supply is more than proportionate to
the fall in the demand, the equilibrium price will go up.

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Theory of Production

A layman understands the term ‘production’ as either growing crops or manufacturing of articles or
making some material etc. In economic sense, production refers to the process of creating or adding
utility into a matter or a thing in order to make it more useful to satisfy human wants. Therefore, the
work of lawyers, teachers, accountants, etc., also account as production, since the services provided
by them provide utility and satisfy the wants of the people. In other words, production is any
economic activity which is directed towards the satisfaction of the wants of people by converting
physical inputs into physical outputs.

In fact, the performance of an economy is judged by the level of its production. Those countries
which produce goods in large quantities are rich and those which produce little of them are poor.

It should be noted that production should not be taken to mean as creation of matter because,
according to the fundamental law of science, man cannot create matter. What a man can do is only
to create or add utility. When a man produces a chair, he does not create the matter of which the
wood is composed of. He only transforms wood into a chair. By doing so, he adds utility to wood
which did not have utility before.

Creation of utility
Production consists of various processes to add utility to natural resources for gaining greater
satisfaction from them by:
i) Form utility: Most manufacturing processes consist of taking raw material and transforming
them into some items possessing utility, e.g., changing the form of iron ore into a machine. This
may be called conferring utility of form.
ii) Place utility: Changing the place of the resources, from the place where they are of little or no
use to another place where they are of greater use. This utility of place can be obtained by:
1) Extraction from earth e.g., removal of coal, minerals, gold and other metal ores from mines
and supplying them to markets.
2) Transferring goods from where they give little or no satisfaction, to places where their utility
is more. Another example is: coal in coal mines have some use to farmers. But when coal is
transported to markets where human settlements are crowded like the city centers, they
afford more satisfaction to greater number of people, rather than to the miners in the coal
mines.

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iii) Time utility: Making available materials at times when they are not normally available e.g.,
harvested food grains are stored for use till next harvest. Canning of seasonal fruits is
undertaken to make them available during off season. This may be called conferring of utility of
time.
iv) Personal Utility: Making a commodity more useful, by application of skill to goods or services.
It involves making use of personal skills in the form of services like services of doctors, interior
decorators, event organizers, lawyers, accountants etc.
The fundamental purpose of all these activities is the same, namely to create utility in some
manner. So production is nothing but the creation of utilities in the form of goods and services.
Example: In the production of a woolen suit, utility is created in some form or the other.
Firstly wool is changed into woolen cloth at the spinning and weaving mill (utility created by
changing the form). Then, it is taken to a place where it is to be sold (utility added by transporting
it). Since woolen clothes are used only in winter, they will be retained until such time when they
are required by purchasers (time utility). In the whole process, services of various groups of
people are utilized (as that of mill workers, shopkeepers, agents etc.) to contribute to the
enhancement of utility. Thus, the entire process of production is nothing but creation of form
utility, place utility, time utility and/or personal utility.

Factors of production
In the production process, a commodity has to pass through many stages before it ultimately reaches
the consumer. There are mainly four factors which help in the production process. They are:
- Land
- Labour
- Capital
- Entrepreneur or enterprise or organization
All the above factors have to be used jointly to produce the goods and services. These factors are
collectively known as the factors of production. Now, let us discuss each of these factors in detail.

Land: The term ‘land’ is used in a special sense in Economics. It does not mean soil or earth’s
surface alone, but refers to all free gifts of nature which would include besides the land, in common
parlance, natural resources, fertility of soil, water, air, natural vegetation etc. It becomes difficult at
times to state precisely as to what part of a given factor is due solely to the gift of nature and what
part belongs to human effort. Therefore, as a theoretical concept, we may list the following
characteristics which would qualify a given factor to be called land:

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Characteristics of land:
a) Land is a free gift of nature: No human effort is required for the production of land. It existed
even before the evolution of mankind.
b) Supply of land is fixed: The total geographical area of land is fixed. The supply of land is fixed.
It can’t be increased or decreased according to our requirements.
c) Land is not mobile: The physical movement of land is impossible. Land can’t be shifted or
moved from one place to another place.
d) Land is indestructible: According to Ricardo, the production power of soil is indestructible
in the sense that the properties of land cannot be destroyed. Even if its fertility gets depleted, it
can be restored.
e) Land varies in quality: Land is not uniform in quality or fertility. No two pieces or plots of
land are uniform in fertility. Some lands will be more fertile and some will be less fertile.
f) Land is the primary and passive factor of production: All kind of economic activities
have to take place on land. Hence it is the primary factor of production. Left to itself, it will not
produce anything on its own, thus termed as passive factor of production.
g) It has different uses: Land is said to be a specific factor of production in the sense that it does
not yield any result unless human efforts are employed. Land varies in fertility and uses.

Labour: The term ‘labour’, means mental or physical exertion directed to produce goods or
services. Labour refers to various types of human efforts which require the use of physical exertion,
skill and intellect. It is, however, difficult to say that in any human effort all the three are not required
in equal proportion; the proportion of each might vary. Labour, to have an economic significance,
must be one which is done with the motive of some economic reward. Anything done out of love and
affection, although very useful in increasing human well-being, is not labour in the economic sense.
It is for this reason that the services of a house-wife are not treated as labour, while those of a maid
servant are treated as labour. If a person sings before his friends just for the sake of pleasure, it is
not considered as labour despite the exertion involved in it. On the other hand, if a person sings
against payment of some fee, then this activity signifies labour.

Characteristics of labour:
a) It is inseparable from the labourer: This means that only the labour is sold whereas the
producer of labour retains his capacity to work. Thus labour cannot be separated from the
labourer.

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

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Machine tools and instruments, factories, dams, canals, transport equipment etc., are some of the
examples of capital. All of them are produced by man to help in further production of goods.

Types of Capital:
a) Fixed capital is that which exists in a durable shape and renders a series of services over a
period of time. For example tools, machines, etc.
b) Circulating capital is another form of capital which performs its function in production in a
single use and is not available for further use. For example, seeds, raw materials, etc.
c) Real capital refers to physical goods such as building, plant, machines, etc.
d) Human capital refers to human skill and ability. This is called human capital because a good
deal of investment has gone into creation of these abilities in humans.
e) Tangible capital can be perceived by senses whereas intangible capital is in the form of certain
rights and benefits which cannot be perceived by senses. For example, goodwill, patent rights,
etc.
f) Individual capital is the personal property owned by an individual or a group of individuals.
g) Social Capital is what belongs to the society as a whole in the form of roads, bridges, etc.

Capital formation: Capital formation means creating more and more capital assets and adding
that to the existing stock of capital. Hence, it can be termed as a form of investment. In order to
accumulate capital goods, some current consumption has to be sacrificed. This is because, if all that
is produced is used for current consumption and nothing is stored for the future, then the future
productive capacity will decline. It is not only required for creating additional productive capacity,
but also for replacement and renovation of existing machinery and equipment.It is prudent to cut
down some of the present consumption and direct part of it to the making of capital goods such as
tools and instruments, machines and transport facilities, plant and equipment etc. They will not only
increase the efficacy of production efforts but also will make possible the expansion of output of
consumer goods in the future.

Stages of capital formation: We can say that capital can be accumulated through savings. But
savings alone is not responsible for capital formation because, if the savings of individual lie idle, no
capital formation takes place. Thus, the savings of all the individuals are accumulated and invested
in a profitable venture to fetch returns which would result in capital accumulation. Thus, capital is
accumulated in three stages.
1. Creation of savings: Savings are very essential for capital formation. However, the ability to
save depends upon various factors like:

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Income of the individuals: Generally, higher the income, higher would be the ability to save.
Willingness to save: An individual may have surplus income which he can save. But he must
have the willingness to create savings. Willingness to save depends upon the interest of an
individual to have a secure future.
Savings are done by the individuals or households, and Government saves by way of tax
collections and profits of PSU’s. It has been noticed that individuals of an underdeveloped
country use their income for current consumption rather that for future consumption. Thus, the
savings of an underdeveloped country is far lesser than those of developed countries. This is why
the developed countries become richer quickly when compared to underdeveloped countries.
2. Mobilization of savings: If the savings of the individuals lie idle, they are of no use to the
economy. Thus, financial institution like banks must collect deposits of all the small investors
and make them available to the prospective investors to invest the money and create capital.
3. Utilization of savings or investment: The savings must be made available to the
entrepreneurial class who are prepared to bear the risk of the business and invests them in
profitable ventures which would create new capital assets.
Entrepreneur: Having explained the three factors namely land, labour and capital, we now turn to the
explanation of the fourth important factor, namely, the entrepreneur. It is not enough to say that
production is a function of land, capital and labour. There must be some factor which mobilises these
factors, combines them in the right proportion, initiates the process of production and bears the risks
involved in it. This factor is known as the entrepreneur.
Functions of an entrepreneur: An entrepreneur performs the following functions in general:
i) Initiating a business enterprise and resource co-ordination: The first and the foremost
function of an entrepreneur is to initiate a business enterprise. For this, he has to collect different
factors of production such as labour, capital, land etc. and bring about coordination among them.
These various other factors of production are paid fixed contractual remuneration: labour at fixed rate
of wages, land or factory building at a fixed rent for its use and capital at a fixed rate of interest. The
surplus, if any, after all the fixed costs and variable costs are met, accrues to the entreprenuer as his
reward for his efforts and risktaking.
Thus, the reward for an entrepreneur, that is a profit, is not fixed. He may earn profits, or incur losses.
Other factors get their payment irrespective of whether the entrepreneur makes profits or losses.
ii) Risk bearing or uncertainty bearing: The ultimate responsibility for the success and survival of
business lies with the entrepreneur. What is planned and anticipated by the entrepreneur may not
come true and the actual course of events may differ from what was anticipated and planned. The
economy is dynamic and changes occurr everyday. The demand for a commodity, the cost structure,
fashions and tastes of the people, and government’s policy regarding taxation, credit, interest rate etc.

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may change. All these changes bring about changes in the cost or demand conditions of a business
firm. It may happen that as a result of certain broad changes which were not anticipated by the
entrepreneur, the firm has to incur heavy losses. Thus, the entrepreneur has to bear these financial
risks. Apart from financial risks, the entrepreneur also faces technological risks which arise due to the
inventions and improvements in techniques of production, making the existing techniques and
machines obsolete. The entrepreneur has to assess and bear the risks. These risks are different from
the risks like risks of fire, theft, burglary etc. which can be insured against.
These risks which cannot be insured are also called uncertainties and the entrepreneur earns profits
because he bears uncertainty in a dynamic economy where changes occur every day.

Innovations: One of the important functions of an entrepreneur is to introduce innovations. Innovations,

in a very broad sense, include the introduction of new or improved production methods, utilisation of new or
improved sources of raw-materials, adoption of new or improved forms of organisation, introduction of new
or improved products, opening of new or improved markets etc. According to Schumpeter, the task of the
entrepreneur is to continuously introduce new innovations.

Production function:
A simple words, production is a process of converting physical input into physical output. The relationship
between input and output expressed in the form of a mathematical equation is called the production function.
It states the maximum amount of output that can be produced with the given amount of inputs or minimum
inputs needed to produce a given quantity of output. Inputs refer to the factor services which are used in
production i.e. land, labour, capital and enterprise. Output refers to the volume of goods produced. The
production function is given as:
Q = f (La, L, K, O)
Where,
Q = Quantity
L = Land
L = Labour
K = Capital
O = Organization
The production function can be classified into two groups/categories.

Short run production function

Short run is a period of time which is too short for a firm to install a new capital equipment to increase
production. In the short run, production will increase when more units of variable factors are used with fixed
factors. In short run, at least one factor is fixed. Short run production function is known as “Law of Variable
Proportions”. Functions are divided into two parts. Namely:-

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➢ Fixed inputs: are those factors, the quantity of which remains constant irrespective of the level of output
produced by a firm. Ex., land, building, etc.
➢ Variable inputs: are those factors, the quantity of which varies (only to a limited extent) with variations
in the levels of output produced by a firm. Ex, Wages, power, working hours of the labourers etc.

Long run production function: Long run is a period of time in which all the factors of production are
variable. Long run production function is known as the “law of returns to scale”.

Assumptions of Production Function:

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

Cobb-Douglas production function:

In economics, the Cobb-Douglas functional form of production functions is widely used to represent the
relationship of an output to inputs. It was proposed by Kunt Wick sell (1851-1926), and tested against
statistical evidence by Charles Cobb and Paul Douglas in 1928.
In 1928 Charles Cobb and Paul Douglas a published a study in which they modelled the growth of the economy
in manufacturing industry during the period 1899-1922. They considered a simplified view of the economy
in which production output is determined by the amount of labour involved and the amount of capital
invested. The conclusion drawn from this famous statistical study is that labour contributed about 3/4 th and
capital about 1/4th of the increase in the manufacturing production. The function they used to model
production was of the form:

Q = KLaC(1-a)
Where,
Q = total output/production,
L = Quantity of labour,
K anda are the positive constants and C is the amount of capital,
Output elasticity measures the responsiveness of output to a change in levels of either labour or capital
used in production, ceteris paribus. For example if a = 0.15, a 1% increase in labour would lead to
approximately a 0.15% increase in output.

Law of variable proportions

Before discussing this law, it would be appropriate to understand the meaning of total product, average
product and marginal product.

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Total Product (TP): Total product is the total output resulting from the efforts of all the factors of
production combined together at any time. If the inputs of all but one factor are held constant, the total
product will vary with the quantity used of the variable factor. Column (1) and (2) of
Table 1 represent a total product schedule.
Quantity of labour Total Product (TP) Average Product (AP) Marginal Product (MP)
1 100 100.0 100
2 210 105.0 110
3 330 110.0 120
4 440 110.0 110
5 520 104.0 80
6 600 100.0 80
7 670 95.7 70
8 720 90.0 50
9 750 83.3 30
10 760 76.0 10
11 740 67.2 –20

We find that when one unit of labour is employed, the total product is 100 units. When two units of labour
are employed, the total product rises to 210 units. The total product goes on rising as more and more units of
labour are employed. With 10 units of labour, the total product rises to 760 units. When 11 units of labour are
employed, total product falls to 740 units.

Average Product (AP): Average product is the total product per unit of the variable factor. It is shown as
a schedule in column (3) of Table 1. When one unit of labour is employed, average product is 100, when two
units of labour are employed, average product rises to 105. This goes on, as shown in Table 1.

Marginal Product (MP): Marginal product is the change in total product per unit change in the quantity
of variable factor. In other words, it is the addition made to the total production by an additional unit of input.
The computed value of the marginal product appears in the last column of Table 1. For example, the MP
corresponding to 4 units is given as 110 units. This reflects the fact that an increase in labour from 3 to 4
units, increased output from 330 to 440 units.

Relationship between Average Product and Marginal Product: Both average product and marginal
product are derived from the total product. Average product is obtained by dividing total product by the
number of units of variable factor and marginal product is the change in total product resulting from a unit
increase in the quantity of variable factor. The various points of relationship between average product and
marginal product can be summed up as follows:
i) When average product rises as a result of an increase in the quantity of variable input, marginal product
is more than the average product.

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ii) When average product is maximum, marginal product is equal to average product. In other words, the
marginal product curve cuts the average product curve at its maximum.
iii) When average product falls, marginal product is less than the average product.
Table 1 and Figure 1 confirm the above points of relationship.
The law of variable proportions or the law of diminishing returns examines the production function with one
factor variable, keeping quantities of other factors fixed. In other words, it refers to input-output relationship,
when the output is increased by varying the quantity of one input. This law operates in the short run ‘when
all the factors of production cannot be increased or decreased simultaneously (for example, we cannot build
a plant or dismantle a plant in the short run).

The law operates under certain assumptions which are as follows:

1. The state of technology is assumed to be given and unchanged. If there is any improvement in technology,
then marginal and average product may rise instead of falling.
2. There must be some inputs whose quantity is kept fixed. This law does not apply to cases when all factors
are proportionately varied. When all the factors are proportionately varied, laws of returns to scale are
applicable.
3. The law does not apply to those cases where the factors must be used in fixed proportions to yield output.
When the various factors are required to be used in fixed proportions, an increase in one factor would not
lead to any increase in output i.e., marginal product of the variable factor will then be zero and not
diminishing.
4. We consider only physical inputs and outputs and not economic profitability in monetary terms. The law
states that as we increase the quantity of one input which is combined with other fixed inputs, the
marginal physical productivity of the variable input must eventually decline. In other words, an increase
in some inputs relative to other fixed inputs will, in a given state of technology, cause output to increase;
but after a point, the extra output resulting from the same addition of extra inputs will become less and
less.
The behaviour of output when the varying quantity of one factor is combined with a fixed quantity of the
others can be divided into three distinct stages or laws. In order to understand these three stages or laws,
we may graphically illustrate the production function with one variable factor.
In this figure, the quantity of variable factor is depicted on the X axis and on the Y-axis is measured the
Total Product (TP), Average Product (AP) and Marginal Product (MP). As the figure shows TP curve goes
on increasing up to a point and after that it starts declining. A Pand MP curves first rise and then decline;
MP curve starts declining earlier than the AP curve. The behaviour of these Total, Average and Marginal
Products of the variable factor consequent on the increase in its amount is generally divided into three
stages (laws) which are explained below.

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Stage 1: The Law of Increasing Returns: In this stage, total product increases at an increasing rate
upto a point (in figure upto point F), marginal product also rises and is maximum at the point
corresponding to F and average product goes on rising. From point F onwards during the stage one, the
total product goes on rising but at a diminishing rate. Marginal product falls but is positive. The stage 1
ends where the AP curve reaches its highest point.
Thus in the first stage the AP curve rises throughout whereas the marginal product curve first rises and
then starts falling after reaching its maximum. It is to be noted that the marginal product although starts
declining, remains greater than the average product throughout the stage so that average product
continues to rise.
Explanation of the law: The law of increasing returns operates because of following reasons
1) In the beginning the quantity of fixed factors is abundant relative to the quantity of the variable factor.
As more units of variable factor are added to the constant quantity of the fixed factors then the fixed
factors are more intensively and effectively utilised i.e., the efficiency of the fixed factors increases as
additional units of the variable factors are added to them. This causes the production to increase at a
rapid rate. This happens because, in the beginning some amount of fixed factor remained unutilised
and, therefore, when the variable factor is increased, fuller utilisation of the fixed factor becomes
possible and it results in increasing returns.

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A question arises as to why the fixed factor is not initially taken in a quantity which suits the available
quantity of the variable factor. The answer is that, generally those factors are taken as fixed which are
indivisible. Indivisibility of a factor means that due to technological requirements, a minimum amount
of that factor must be employed whatever the level of output.

Thus, as more units of the variable factor are employed to work with an indivisible fixed factor, output
greatly increases due to fuller utilisation of the latter.
2) The second reason why we get increasing returns at the initial stage is that as more units of the variable
factors are employed, the efficiency of the variable factors itself increases. This is because with
sufficient quantity of the variable factor introduction of division of labour and specialisation
becomes possible which results in higher productivity.

Stage 2: Law of diminishing returns: In stage 2, the total product continues to increase at a
diminishing rate until it reaches its maximum point H, where the second stage ends. In this stage, both
marginal product and average product of the variable factor are diminishing but are positive. At the end
of this stage i.e., at point M (corresponding to the highest point H of the total product curve), the marginal
product of the variable factor is zero. Stage 2, is known as the stage of diminishing returns because both
the average and marginal products of the variable factors continuously fall during this stage. This stage is
very important because the firm will seek to produce in its range.
Explanation of the law: The question arises as to why we get diminishing returns after a certain
amount of the variable factor has been added to the fixed quantity of that factor. As explained above,
increasing returns occur primarily because of the more efficient use of fixed factors as more units of the
variable factor are combined to work with it. Once the point is reached at which the amount of variable
factor is sufficient to ensure efficient utilisation of the fixed factor, any further increases in the variable
factor will cause marginal and average product to decline because the fixed factor then becomes
inadequate relative to the quantity of the variable factor. Continuing the above example, when four men
were put to work on one machine, the optimum combination was achieved. Now, if the fifth person is put
on the machine, his contribution will be nil. In other words, the marginal productivity will start
diminishing.
1) The phenomenon of diminishing returns, like that of increasing returns, rests upon the indivisibility
of the fixed factor. Just as the average product of the variable factor increases in the first stage when
better utilisation of the fixed indivisible factor is being made, so the average product of the variable
factor diminishes in the second stage when the fixed indivisible factor is being worked too hard.
2) Another reason offered for the operation of the law of diminishing returns is the imperfect
substitutability of one factor for another.

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Stage 3: Law of negative returns: In Stage 3, total product declines, MP is negative, average product
is diminishing. This stage is called the stage of negative returns since the marginal product of the variable
factor is negative during this stage.
Explanation the law: As the amount of the variable factor continues to be increased to a constant
quantity of the other, a stage is reached when the total product declines and marginal product becomes
negative.
1) The quantity of the variable factor becomes too excessive relative to the fixed factor so that they get in
each other’s ways with the result that the total output falls instead of rising. In such a situation, a
reduction in the units of the variable factor will increase the total output.

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

Long run production function – Law of returns to scale:

We shall study the behaviour of output in response to a change in the scale. A change in scale means that all
factors of production are increased or decreased in the same proportion. Returns to scale may be constant,

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

Constant returns to scale: As stated above, constant returns to scale means that with the increase in the
scale in some proportion, output increases in the same proportion. It has been found that production function
for the economy as a whole corresponds to production function exhibiting constant returns to scale. Also, it
has been found that an individual firm passes through a long phase of constant returns to scale in its lifetime.
Constant return to scale is otherwise called as “Linear Homogeneous Production Function”

Increasing returns to scale: As stated earlier, increasing returns to scale means that output increases in
a greater proportion than the increase in inputs. When a firm expands, increasing returns to scale are
obtained in the beginning. Another reason for increasing returns to scale is the indivisibility of factors. Some
factors are available in large and lumpy units and can, therefore, be utilised with utmost efficiency at a large
output. Returns to scale may also increase because of greater possibilities of specialisation of land and
machinery.

Decreasing returns to scale: When output increases in a smaller proportion with an increase in all inputs,
decreasing returns to scale are said to prevail. When a firm goes on expanding by increasing all inputs,
diminishing returns to scale set in. Decreasing returns to scale eventually occur because of increasing
difficulties of management, coordination and control. When the firm has expanded to a very large size, it is
difficult to manage it with the same efficiency as before.

In the table given below we take labour and capital as factors of production.
Total Output Total Output Marginal Output
1K+2L 50 50
2K+4L 110 60
3K+6L 180 70
4K+8L 250 70
5K+10L 300 50
6K+12L 335 35

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Observations:
The marginal output which is most important here
➢ Increases at a rapid rate then the rate of increase in the input –
in the 1st stage. Hence it is increasing returns to scale.
➢ Increases in the same ratio as increase in the input – in the 2nd
stage. Hence it is constant returns to scale.
➢ Increases in a lesser proportion as you employ more and more
of K & L – in the 3rd stage. Hence it is decreasing return to scale.

Differences between law of variable portions and returns to scale:

Basis of difference Law of variable proportions Law of returns to scale
Time period Applies in the short run Applies in the long run
Variable and fixed factors Only variable factors are changed All factors are increased simultaneously.
units of fixed factors remain the No distinction between fixed and
same variable factors.
Stages There are 3 stages There are 3 stages
- Increasing returns - Increasing returns
- Diminishing returns - Constant returns
- Negative returns - Decreasing returns

PRODUCTION OPTIMISATION
Normally, a firm is interested to know what combination of factors of production (or inputs) would minimise
its cost of production. This can be known with the help of isoquants and isocost lines.

Isoquants: Isoquants are similar to indifference curves of the theory of consumer behaviour.
An isoquant represents all those combinations of inputs which are capable of producing the same level of
output. Isoquants are also called equal-product or iso-product curves. Since an equal-product curve
represents all those combinations of inputs which yield an equal quantityof output, the producer is indifferent
between them. Therefore, another name for an isoquant is production-indifference curve. The concept of
isoquant can be easily understood with the help of the following schedule.

Factor combination Factor L Factor K

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

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An ISO – Quant Curve always slopes downward from left to right i.e., It should always a
Negative Slope.
This is because, if producer wants to increase the proportion
of one factor, it is possible only by reducing the proportion of
another factor because of limited resources. The negative
slope of Isoquants implies substitutability between the
inputs. It means that if one of the inputs is reduced, the other
inputs has to be so increased that the total output remains
unaffected. To represent this concept, it should always slope
downward. An ISO- Quant will be always convex to the
origin.The Law of Diminishing Marginal Rate of Technical
Substitution (MRTS) could be explained only if it is convex to
the origin. The rate at which one factor is substituted for
another factor is known as Technical Substitution.

Iso-cost or Equal-cost Lines: Iso-cost line represents the prices of factors. It shows various combinations
of two factors which the firm can buy with given outlay. Suppose a firm has Rs. 100 to spend on the two
factors L and K. If the price of factor L is Rs. 10 and that of K is Rs. 20, the firm can spend its outlay on L and
K in various ways. It can spend the entire amount on L and thus buy 10 units of L and zero units of K or it can
spend the entire outlay on K and buy 5 units of it with zero units of X factor. In between, it can have any
combination of L and K.
Factor combination Factor L Cost of L Factor K Cost of K Total cost
A 0 0 5 100 100
B 2 20 4 80 100
C 4 40 3 60 100
D 6 60 2 40 100
E 8 80 1 20 100
F 10 100 0 0 100

We can show iso-cost line diagrammatically also. The X-axis shows the
units of factor L and Y-axis the units of factor K. When entire Rs. 100
are spent on factor L we get OC/P k and when entire amount is spent
on factor K we get OC/PL. The straight line C/Pkto C/PL will pass
through all combinations of factors L and K which the firm can buy
with outlay of Rs. 100. The line C/P kto C/PL is called iso-cost line.

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Theory of Cost

Meaning of cost
The amount of resources used in the manufacturing of goods or rendering of services and expressed in
monetary terms is known as costs. These resources may be tangible like materials or intangible like labour.

Meaning of cost analysis:

We have seen that production analysis is mainly concerned with the physical aspects of production. In cost
analysis, we study the financial aspects of production. In other words, cost analysis refers to the study of
behaviour of cost in relation to one or more production criteria, viz,., seize of output, scale of operations, price
of factors of production, etc.

Cost function:
It refers to the mathematical relationship between cost of a product and the various determinants of costs. In
cost function, the dependent variable is unit cost or total cost and the independent variables are the prices of
factor, scale of operations, technology, level of capacity utilization etc.
Symbolically, the cost function is C = f (Q).
Where
C = Cost and
Q = Output

Cost concept:
In order to understand the cost function, we have to understand the various concept of cost as below:

Explicit and Implicit Cost:

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

Accounting costs and economic costs:

- Accounting costs are all the payments and charges made by the entrepreneur to the suppliers of various
productive factors. Accounting costs are also explicit costs.

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- Economic costs not only take the accounting costs into consideration, but also include the amount of
money which the entrepreneur could have earned if he had invested his money and sold his services and
other factors in the next best alternative uses. Thus, economic costs include both, accounting costs and
implicit costs.
The concept of economic costs is very important because an entrepreneur is said to be earning profits
only when his revenues are able to cover both, the explicit as well as implicit costs.
Note: Revenue refers to sales receipts.

Outlay costs and opportunity costs:

Outlay costs are those costs which involve financial expenditure and are recorded in the books of accounts.
These costs involve actual expenditure of funds. It is same as explicit costs.

Opportunity costs refers to the cost of the foregone opportunity. It can also be represented as the difference
between the opportunity selected and the opportunity rejected. These costs are not recorded in the books of
accounts. They are also known as alternative costs.
Example: A farmer who produces wheat can produce potatoes with the same factors. Therefore, the
opportunity cost of a quintal of wheat is the amount of output of potatoes given up. These cost help is decision
making in scarcity of resources.

Direct costs and indirect costs:

Direct costs are those costs which are readily identifiable and traceable to a particular product, service,
operation or a plant. For example, cost of raw material used in manufacture, wages paid to workers of
administration department. These costs are also known as traceable costs.
Indirect costs on the other hand are not readily identified or visibly traceable to a particular product service,
operation or plant. These are the common costs.
Example: factory rent and advertisement expenses. These costs are also known as non-traceable costs.

Fixed and variable costs:

Fixed costs refer to all the money expenses incurred by the manufacturer irrespective of the output level.
They are also known as unavoidable contractual costs as they have to be paid as long as the operations are
going on. For example, rent of a factory building, interest on loans. Fixed costs are those costs which do not
vary either with expansion or contraction of output, up to a certain level.
Variable costs refer to money expenses which vary directly and proportionately with the output.
Example: Wages and cost of raw materials. It is left to the discretion of the management whether to incur
these costs or not. E.g. – If the production process is stopped for some time, expense such as wages, cost of
raw materials would not be incurred.

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Sunk costs:
Sunk costs are those that do not alter by varying the nature or level of business activity. Sunk costs are
generally not taken into consideration in decision – making as they do not vary with the changes in the future.
Sunk costs are a part of the outlay/actual costs. E.g. – Amortisation of past expenses such as depreciation.

Book costs:
The cost that has not been incurred in actual but are recorded in the books of accounts by making the
provision in the books. They are recorded to the take the advantage of tax. E.g. Provision for taxation,
Provision for bad debt.
Out of pocket cost: The cost incurred to meet the payment of outside parties is called ‘out of pocket cost’.
They fall in the category of out of pocket costs. E.g. Rent, wages, interest.
Incremental costs: These are the cost which incurred when there is a change in the level of business
activity. They are also called avoidable or differential costs. E.g. – deleting the product from the product line.

Short run costs:

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

Total Fixed Cost (TFC)

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

Total Variable Cost (TVC)

Variable costs refer to those costs which vary with the output. The
total variable cost curve is inverse S- Shaped and starts from the
origin which shows that if production is stopped, variable costs
are not incurred. As the production increases, the total variable
cost also increases. Initially, as more of the variable factor is
combined with the fixed factor, total productivity increase at an

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increasing rate, and total variable cost increases at a diminishing rate. But after this point, as more of the
variable factor is combined with the fixed factor, variable cost increases at an increasing rate. E.g. – Expenses
incurred on variable inputs like labour, raw materials, power and fuel etc.

Semi Variable cost:

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

Stair – Step Variable Cost:

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

Total Cost (TC)

It is the total amount of money spent by the manufacturer to
produce a given level of output. Thus, it is the sum total of
total fixed cost and total variable cost.
Symbolically,
TC = TFC + TVC
TC = Cost per unit x Number of units manufactured

Average Fixed Cost (AFC)

It refers to the total fixed cost spent by the manufacturer to
produce one unit of output. It is obtained by dividing the total fixed cost by the number of units of the
commodity produced.

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AFC = TFC / Q. where Q is the number of units produced

Since total fixed costs are constant, the average fixed cost curve diminishes with the output. Thus, the average
fixed cost curve is a rectangular hyperbola.

Average Variable Cost (AVC)

It refers to the total variable cost incurred by the manufacturer to produce one unit of output. It is the total
variable cost divided by the number of units of output produced.
AVC = TVC / Q, Where Q is the number of units produced
Average variable cost curve is U – Shaped. As the output increases, the AVC will fall up to the normal capacity
of output due to the operation of increasing returns. But, beyond the normal capacity of output, the AVC will
rise due to the operation of diminishing returns to a factor.

Average Total Cost (ATC)

It is the sum of the average variable cost and average fixed cost. It is also known as the unit cost.
Symbolically,
ATC = AFC + AVC or ATC = TC / Q
The ATC curve will always be U-Shaped because of the operation of the law of returns to a factor.

Marginal Cost (MC):

It is the addition made to the total cost by the production of an additional unit of output.
Example: If is costs Rs. 500 produce 10 units of a commodity and Rs. 550 to produce 11 units of commodity,
then MC would be Rs. 50 (i.e. 550 – 500).
MC is obtained by calculating the change in TC as a result of a change in the total output. Thus, MC is the rate
at which TC changes with output. Hence,
MC = ∆TC / ∆ TQ
The MC curve is U-shaped. The shape of the cost curve is determined by the law of variable proportions. If
increasing returns is in operation, the marginal cost curve will decline, as the cost decreases with the increase
in output. While the diminishing return is in operation, the MC curve will increase as it is a situation of
increasing cost.
MC = TCn – TCn-1

We notice that, in the beginning, both AVC and AFC curves fall. Therefore, the ATC curve also falls sharply.
When the AVC curve begins to rise, AFC curve still falls steeply, the ATC curve continues to fall. This is

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because; the fall in AFC curve is greater than the rise in AVC. But as output increases further, there is a sharp
rise in AVC which offsets the fall in AFC. Therefore, ATC curve fist falls, reaches its minimum and then rises.
The ATC curve changes because of MC. Thus, the MC curve passes through the minimum of the average cost
curve.
Let us now discuss the cost concepts in the form of a table.
Units of Total Total Total Average Average Average Marginal
output fixed variable cost fixed cost variable cost cost
cost cost cost
0 1500 0 1500 - - - -
20 1500 200 1700 75.00 10.00 85.00 10.00
50 1500 500 2000 30.00 10.00 40.00 10.00
100 1500 900 2400 15.00 9.00 24.00 8.00
200 1500 1500 3000 7.5 7.5 15.00 6.00
500 1500 6500 8000 3.00 13.00 16.00 16.67
1000 1500 15000 16500 1.5 15.00 16.50 17.00

Note: - Fixed costs do not change with output. Therefore, the average fixed cost comes down.
- Variable cost increases, but not in the same proportion as the increase in output.
- Marginal cost declines gradually and then increases.

Relationship between AC and MC:

The relationship between these two cost curves is as follows:
- MC < AC when average cost falls due to an increase in output.
- MC > AC when average cost rises due to an increase in output.
- MC = AC when average cost is at minimum, i.e. marginal cost curve cuts average cost curve at its minimum
point.

Long run average cost curve (LAC curve)

Long run is a period of time during which the firm can vary all its inputs. Thus, all the factors in the long run
are variable, unlike the short run, where one variable factor is fixed and others are variable. For instance, in
the short run, the firm’s location is fixed, but in the long run, the firm can move from one place to another. A
long run cost curve represents the functional relationship between output and the long run cost of production.
A long run average cost curve is made up of many short run average cost curve as a business in long run will
be able to change all its inputs. Let us understand this with the help of a diagram. To understand how long
run average cost curve is derived we consider three short run average cost curves. Short run cost curves are
also called as plant curves. In the short run the firm can be operating on any short run average cost curves
given the size of the plant. Given the size of the plant, the firm will be increasing or decreasing its output by
changing the amount of the variable inputs. But in the long run, the firm chooses with which size of plants or
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on which short average cost curve it should operate to produce a given level of output so that total cost is
minimum. This may be depicted in the form of a diagram.

As shown in the diagram, to produce up to OA amount of output, the firm will operate on the SACI though it
can operate on SAC2 selecting SAC1 would results in lower cost than SAC2. For example, if the level of output
OA is produced with SAC1, it will cost AL per unit and same quantity is produced on SAC2 it will cost AH
which is more than AL. similarly, if the firm plans to produce OC quantity, it will select SAC2 plant, instead
of SAC1, where cost is CK which is lesser than CJ. Hence in the long run the firm has a choice in the
employment of plant and it will employ that plant which yields minimum possible unit cost for producing a
given output.

Since in the long run the size of the plant can be varied by infinitely small gradations, there will be numerous
average cost curves. By combing all these short run average cost curves, Long run average cost curve may be
obtained, which would be a smooth curve enveloping all these short run average cost curves. Hence it is
known as Envelop Curve or Planning Curve. Every point on the long run average cost curve will be a tangency
point with short run AC curve. If a firm desires to produce any particular output, it then builds a
corresponding plant and operates on the corresponding short run average cost curve. This could be shown in
the form of a graph.

For producing OM level of output, the corresponding point on the LAC curve is G and Short run average cost
curve is SAC2, is tangent to the long run AC at this point. If larger output OV has to be produced then it uses
SAC3. It should be noted that LAC is not a tangent to the minimum points of the SAC Curves. When the LAC
curve is declining it is tangent to the falling portion of the short run cost curves and when the LAC curve is
rising it is tangent to the rising portions of the short run cost curves. LAC curve would be always U shape
because of operation of returns to scale.

Thus, for producing output less than OQ at the lowest possible unit cost, the firm will construct the relevant
plant and operate it at less than its full capacity, i.e., at less than its minimum average cost of production. On
the other hand, for producing output larger than OQ, the firm will construct a plant and operate it beyond its
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optimum capacity. OQ is the optimum output. This is because, OQ is being produced at the minimum point
of LAC and the corresponding SAC i.e. SAC4. Other plants are either used at less than their full capacity or
more than their full capacity. Only SAC4 is being operated at the minimum point.
Problem on cost:
1. Calculate TFC, TVC, AVC, AFC, AC and MC from the following information.
Units Total cost (TC)
0 50
1 130
2 180
3 190
4 220
5 270

Solution:
Units TC TFC TVC AFC AVC AC MC
0 50 50 0 0 0 0 0
1 130 50 80 50 80 130 80
2 180 50 50 25 25 90 50
3 190 50 10 16.67 3.3 63.33 10
4 220 50 30 12.5 7.5 55 30
5 270 50 50 10 10 54 50

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

The figure depicting long-run average cost curve is arrived at

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

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ECONOMIES AND DISECONOMIES OF SCALE

The Scale of Production

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

Internal Economies and Diseconomies: We saw that returns to scale increase in the initial stages and
after remaining constant for a while, they decrease. The question arises as to why we get increasing returns
to scale due to which cost falls and why after a certain point we get decreasing returns to scale due to which
cost rises. The answer is that initially a firm enjoys internal economies of scale and beyond a certain limit it
suffers from internal diseconomies of scale. Internal economies and diseconomies are of the following main
kinds:
i) Technical economies and diseconomies: Large-scale production is associated with economies of
superior techniques. As the firm increases its scale of operations, it becomes possible to use more
specialised and efficient form of all factors, specially capital equipment and machinery. For producing
higher levels of output, there is generally available a more efficient machinery which when employed to
produce a large output yields a lower cost per unit of output. The firm is able to take advantage of
composite technology whereby the whole process of production of a commodity is done as one composite
unit. Secondly, when the scale of production is increased and the amount of labour and other factors
become larger, introduction of greater degree of division of labour and specialisation becomes possible
and as a result cost per unit declines. There are some advantages available to a large firm on account of
performance of a number of linked processes. The firm can reduce the inconvenience and costs associated
with the dependence on other firms by undertaking various processes from the input supply stage to the
final output stage.

However, beyond a certain point, a firm experiences net diseconomies of scale. This happens because
when the firm has reached a size large enough to allow utilisation of almost all the possibilities of division
of labour and employment of more efficient machinery, further increase in the size of the plant will bring
about high long-run cost because of difficulties of management. When the scale of operations becomes

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too large, it becomes difficult for the management to exercise control and to bring about proper
coordination.

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

However, as the scale of production increases beyond a certain limit, managerial diseconomies set in.
Communication at different levels such as between the managers and labourers and among the managers
become difficult resulting in delays in decision making and implementation of decisions already made.
Management finds it difficult to exercise control and to bring in coordination among its various
departments. The managerial structure becomes more complex and is affected by greater bureaucracy,
red tapism, lengthening of communication lines and so on. All these affect the efficiency and productivity
of management and that of the firm itself.

iii) Commercial economies and diseconomies: Production of large volumes of goods requires large
amount of materials and components. A large firm is able to place bulk orders for materials and
components and enjoy lower prices for them. Economies can also be achieved in marketing of the product.
If the sales staff is not being worked to full capacity, additional output can be sold at little or no extra cost.
Moreover, large firms can benefit from economies of advertising. As the scale of production increases,
advertising costs per unit of output fall. In addition, a large firm may also be able to sell its by-products
or process it profitably; something which might be unprofitable for a small firm. There are also economies
associated with transport and storage.

These economies become diseconomies after an optimum scale. For example, advertisement expenditure
and other marketing overheads will increase more than proportionately after the optimum scale.

iv) Financial economies and diseconomies: A large firm has advantages over small firms in matters
related to procurement of finance for its business activities. It can, for instance, offer better security to
bankers and avail of advances with greater ease. On account of the goodwill enjoyed by large firms,
investors have greater confidence in them and therefore would prefer their shares which can be readily
sold on the stock exchange. A large firm can thus raise capital at lower cost.

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However, these costs of raising finance will rise more than proportionately after the optimum scale of
production. This may happen because of relatively greater dependence on external finances.

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

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

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5. Better transportation and marketing facilities: The expansion of an industry resulting from
entry of new firms may make possible the development of an efficient transportation and marketing
network. These will greatly reduce the cost of production of the firms by avoiding the need for
establishing and running these services by themselves. Similarly, communication systems may get
modernised resulting in better and speedy information dissemination.
6. Economies of Information: Necessary information regarding technology, labour, prices and
products may be easily and cheaply made available to the firms on account of publication of
information booklets and bulletins by industry associations or by governments in public interest.

However, external economies may cease if there are certain disadvantages which may neutralise the
advantages of expansion of an industry. We call them external diseconomies. External diseconomies
are disadvantages that originate outside the firm, especially in the input markets. An example of
external diseconomies is rise in various factor prices. When an industry expands the requirement of
various factors of production, such as raw materials, capital goods, skilled labour etc increases.
Increasing demand for inputs puts pressure on the input markets. This may result in an increase in
the prices of factors of production, especially when they are short in supply. Moreover, too many firms
in an industry at one place may also result in higher transportation cost, marketing cost and high
pollution control cost. The government may also, through its location policy, prohibit or restrict the
expansion

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Price Determination in Different Market

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

Thus, the essential features of a market are as follows:

- Two parties in a market i.e., buyers and sellers.
- Contact between them (either directly or indirectly)
- A product which is demanded and sold
- Price of the commodity
- Willingness and ability to buy and sell.

Types of Market:
Markets can be classified on the basis of:
- Area
- Time
- Transaction
- Volume of business
- Status of sellers
- Competition

On the basis of area

On the basis of area, the market can be classified as follows:
Local Market: A local market for a product exists when buyers and sellers of a commodity carry on business
in a particular locality or village or area where the demand and supply conditions are influenced by local
factors only.
Example: Perishable goods like fruits and vegetables and huge commodities as required in construction like
bricks and stones.

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Regional Market: Semi-durable commodities that are demanded and supplied over a region have regional
market.

National Market: When commodities are demanded and supplied throughout the country, there is a
national market. This is a market for durable goods and industrial items.
Example: Wheat, rice, cotton, motor bikes.

International Market: When demand and supply conditions are influenced at the global level, there is an
international market.
Example: Gold, silver, cell phones, handicrafts.

On the basis of time

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

Short period market:

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

Long period market:

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

Very long period market:

During this period, there will be sufficiently long time to introduce any kind of changes in production system.
Over a long period (Secular period), new sources of supply are discovered a new methods of production are
perfected. Hence long run prices will be relatively lower. In the very long period, the equality between supply

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and demand will determine the equilibrium price. Contrary to very short period, in the very long period,
supply plays a more role in determining the price.

On the basis of the nature of transaction.

Spot Market: Spot market refers to a market where goods are physically transacted on the spot.

Future market: It is a market related to those transactions that involves contract of a future date. Good and
services are exchanged at some future date as per the predetermined price.

On the basis of regulation

Regulated market:
In this market, there a vigil check on the transactions and in case of any fraudulent transaction, stringent
measures are taken. The transactions in such a market are statutorily regulated so as to put an end to unfair
practices. Such a market may be for specific products or groups of products.
Example: Stock Market

Unregulated market:
It is called as free market as there are no restrictions on the transactions.

On the basis of the volume of business

Wholesale market:
It is a market in which commodities are bought and sold in large quantities. Usually distributors and
wholesalers buy in huge quantities and sell to retailers.

Retail Market:
It is a market in which commodities are bought and sold in small quantities. It is a market for ultimate
consumers.

On the basis of competition

Types of market structure:
The market structure depends upon the number of sellers in the market. There are different situations in a
market. Sometimes, there are large numbers of sellers, sometimes, a few and sometimes, there is only one
seller. Based on the number of sellers in a market, the market structure can be classified as follows:

Perfect competition: Under this system, many sellers sell identical products to many buyers.
Example: Food grains, vegetable market

Monopoly:
It is a type of market in which there is a single seller of a product which has no substitutes.
Example: Railways, water transport

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Oligopoly:
Under this, there are a few sellers selling homogeneous or similar products to many buyers.
Example: cold drinks, pharmaceutical products.

Duopoly:
This form of market consists of only two sellers selling identical products.

Monopolistic competition:
In this type of market, a large number of sellers sell differentiated products which are close, but not perfect
substitutes, to a large number of buyers.
Example: Market for soaps and detergents, cosmetics, biscuits, ice-creams.
Basis Perfect Monopoly Monopolistic Oligopoly
competition competition
Number of sellers Many One Many A few
Differentiation Homogeneous No substitutes Close but not Differentiated
products perfect substitutes
Entry and exit Free entry/ exit Restricted Free Entry and Exit Restricted
Control over price None Absolute control Some extent Small
Demand curve Horizontal Negative slope Small Negative Kinked curve
slope

Concept of total revenue, average revenue and marginal revenue:

Meaning of revenue:
The amount of money which the firm receives by the sale of its output in the market is known as its revenue.
It is also known as ‘Sales Receipts’. There are three types of Revenue.

Total Revenue:
Total revenue refers to the total amount of money that a firm receives from the sale of its products.
Mathematically, TR = P x Q
Where,
TR = Total Revenue
P = Price
Q = Quantity sold
Example: If the shopkeeper sold 10 boxes of chocolates each at Rs. 500/- then his total revenue would be
TR = PxQ
= 500 x 10
TR = 5,000 Rs.

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Average revenue:
Average revenue is the revenue per unit of the commodity sold. It is calculated by dividing the total revenue
by the number of units sold.
AR = TR / Q
Where,
AR = Average Revenue
TR = Total Revenue
Q = Quantity
Or
AR = P x Q/Q
Where
AR = Average Revenue
P = Price
Q = Quantity sold
Or, AR = P
Thus, average revenue means price of the product.
Example: If the seller made revenue of Rs. 25000 selling 10 sarees, then the average revenue per saree is
AR = TR / Q
= 25000 / 10
AR = Rs. 2,500/-

Marginal Revenue:
Marginal revenue is the addition made to the total revenue by selling one more unit of a commodity
MR = Change in TR ÷ Change in Q
Or,
MR = TRn – TRn-1
Where,
Q = number of units
MRn = Marginal revenue of the nth unit
TRn = Total revenue of n units
TRn-1 = Total revenue of n-1 units
Example: If the total revenue of a merchant by selling 50 mobile phones is Rs. 5,00,000 and by selling 51
mobiles phones, it is Rs. 5,20,000, then MR is
MR51 = TR at 51 – TR at 50
= 5,20,000 – 5,00,000
MR = Rs. 20,000

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Relationship between Total Revenue, Average Revenue and Marginal Revenue:

MR = AR X e -1/e
Where
e = Price elasticity of demand
Thus, if e = 1, MR = 0
If e > 1, MR will be positive
If e < 1, MR will be negative

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

Price – Output determination under different market forms

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

Perfect competition market:

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

Large number of buyers and sellers:

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

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Existence of homogeneous product:

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

Free entry and free exit of firms:

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

Perfect competition market:

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

Perfect mobility of the factors of production:

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

Absence of transport cost:

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

Price and output determination under perfect competition:

Equilibrium of the industry:
Industry consists of large number of independent firms. Each such firm in the industry produces
homogeneous products. When the total output of the industry is equal to the total demand and when it has
no incentive to expand or contract production, we say that the industry is in equilibrium.

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Under equilibrium condition the equilibrium price for a given product is determined by ‘Price mechanism’.
That is the interaction of the forces of demand and supply.

Determination of price:
In an open competitive market, it is the interaction between demand and supply that determines prices.
This can be shown by the following schedule and diagram.
Price of commodity X Demand for commodity X
Rs. 1 50 Units
Rs. 2 35 Units
Rs. 3 15 Units

Market demand schedule is inversely related to the price. Hence the demand curve slopes downwards from
left to right.

Market Supply Schedule:

Price of commodity X Supply of commodity X
Rs. 1 15 Units
Rs. 2 35 Units
Rs. 3 50 Units

Market supply schedule is directly related to the price. Hence the supply curve slopes upwards from left to
right.
The above two tables if put together, gives use an idea of equilibrium price and output.
Price of commodity X Supply of commodity X Demand of commodity
Rs. 1 15 Units 50 Units
Rs. 2 35 Units 35 Units
Rs.3 100 Units 50 Units

At Rs. 2 the quantity demanded is equal to quantity supplied. It is called as the Equilibrium Price.

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

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Equilibrium of a business firm:

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

Total Revenue = Price X Quantity {Total sales receipt}

Average Revenue = Total revenue / Quantity {revenue selling a single unit}
Marginal Revenue = Total revenuen-1. {n = Present unit, n-1 = previous unit} [Revenue from selling
an additional unit]

They cannot increase the price OP individually because of the fear of losing customers to other firms. They
do not try to sell the product below OP because they do not have any incentive for lowering it. They will try to
sell as much as they can at price OP.As such, P-line acts as demand curve for the firm. Thus the demand curve
facing an individual firm in a perfectly competitive market is a horizontal one at the level of market price set
by the industry and firms have to choose that level of output which yields maximum profit.

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Conditions for equilibrium of a firm: As discussed earlier, a firm, in order to attain the equilibrium
position, has to satisfy two conditions:
i) The marginal revenue should be equal to the marginal cost. i.e. MR = MC. If MR is greater than MC, there
is always an incentive for the firm to expand its production further and gain by sale of additional units. If
MR is less than MC, the firm will have to reduce output since an additional unit adds more to cost than
to revenue. Profits are maximum only at the point where MR = MC.
ii) The MC curve should cut MR curve from below. In other words, MC should have a positive slope.

As all the units are priced at the same level, MR is a horizontal line equal to AR line. Note that MC curve cuts
MR curve at two places T and R respectively. But at T, the MC curve is cutting MR curve from above. T is not
the point of equilibrium as the second condition is not satisfied. The firm will benefit if it goes beyond T as
the additional cost of producing an additional unit is falling. At R, the MC curve is cutting MR curve from
below. Hence, R is the point of equilibrium and OQ2 is the equilibrium level of output.

Supply curve of the firm in a competitive market: One interesting thing about the MC curve of a firm
in a perfectly competitive industry is that it depicts the firm’s supply curve.

Suppose the market price of a product is `2 Corresponding to it we have D1 as demand curve for the firm. At
price `2, the firm supplies Q1 output because here MR = MC. If the market price is `3, the corresponding
demand curve is D2. At `3, the quantity supplied is Q2. Similarly, we have demand curves at D3 and D4 and
corresponding supplies are Q3 and Q4. The firm’s marginal cost curve which gives the marginal cost
corresponding to each level of output is nothing but firm’s supply curve that gives various quantities the firm

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will supply at each price. For prices below AVC, the firm will supply zero units because here the firm is unable
to meet even its variable cost. For prices above AVC, the firm will equate price and marginal cost. When price
is high enough to meet the AVC, a firm will decide to continue its production. In fig. 10, at price `2, the AVC
of the firm is covered and therefore, the firm need not shut down. Thus, in perfect competition, the firm’s
marginal cost curve above AVC has the identical shape of the firm’s supply curve.

Short run equilibrium of the firm:

Since a firm in a perfectly competitive market is a price-taker, it has to adjust its level of output to maximise
its profit. The aim of any producer is to maximize his profit. The short run is a period in which the number
and plant size of the firms are fixed. In this period, a firm can produce more only by increasing the variable
inputs. As the entry of new firms or exit of the existing firms is not possible in the short run, the firm, in a
perfectly competitive market, can either earn super-normal profit or normal profit or income loss.

NORMAL PROFITS- When the firm only meets its average cost
(AC), it earns normal profits and normal profit is also included in
average total cost. Normal profit is the normal rate of return on
capital and remuneration for the risk bearing factor of an
entrepreneur. It is also called as break-even point. The diagram
shows that MR = MC at E. The equilibrium output is OQ. Since AR
= AC or OP = EQ, the firm earns normal profits. The figure shows
that MR = MC at E. The equilibrium output is OQ. Since AR=ATC
or OP = EQ, the firm is just earning normal profits.

Super – normal profits:

When the AR of a firm is equal to its average total cost (ATC), it
earns normal profits. When a firm earns super-normal profits, its
AR is more than AC. Thus, a firm earns profits in addition to the
normal rate of profit.
Suppose the cost of producing 1,000 units of a product by a firm
is `15,000. The entrepreneur has invested `50,000 in the
business and normal rate of return in the market is 10 per cent.
Thus the entrepreneur must earn at least ` 5,000 (10% of
50,000) in this particular business. This `5,000 will be shown as
a part of cost. Thus, total cost of production is `20,000 (`15,000
+ 5,000). If the firm is selling the product at `20, it is earning normal profits because AR (`20) is equal to
ATC (`20). If the firm is selling the product at `22 per unit, its AR (`22) is greater than its ATC (`20) and it
is earning supernormal profit at the rate of `2 per unit.

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Losses: The firm can be in an equilibrium position and still makes

losses. This is the position when the firm is minimising losses. When
the firm is able to meet its variable cost and a part of fixed cost it will
try to continue production in the short run. If it recovers a part of the
fixed costs, it will be beneficial for it to continue production because
fixed costs (such as costs towards plant and machinery, building etc.)
are already incurred and in such case it will be able to recover a part
of them. But, if a firm is unable to meet its average variable cost, it
will be better for it to shut down.

Long run equilibrium of the firm:

A firm is in equilibrium if it adjusts its plant so as to produce at the minimum point of its long run average
cost curve which is tangential to the price line. In the long run, the firm will only earn normal profit which is
included in the average cost.
If the firm earns super-normal profits, new firms will be attracted to join the industry which leads to a fall in
profits. If the firm incurs losses, the existing firms will leave the industry in the long run. This will increase
the profits.
The condition for long run equilibrium of the firm is as below:
Long run Marginal Cost (LMC) = Price = Long run Average Cost (LAC).
At equilibrium, the short run marginal cost is equal to the long run marginal cost and the short run average
cost is equal to the long run average cost. Thus, in the long run,
SMC = LMC = SAC = LAC = P = MR
The industry is said to have attained long run equilibrium when:
- All firms earn normal profits i.e. when all the firms are in equilibrium
- When there is no further entry or exit from the market.
In the long run, AR = MR = LAC = LMC at E. since E is the minimum point of LAC, the firm produces output
at OM at the minimum cost. A firm producing output at optimum cost is called an optimum firm.
In the long run, the market mechanism leads to an optimum allocation of resources. Here:
- The output is produced at minimum cost
- Consumers pay minimum possible price which just covers the marginal cost i.e. MC = AR
- Plants are used at full capacity and there is no wastage of resources i.e. MC = AC
- Firms earn only normal profits (AC = AR)
- Firms maximize profits (MC = MR), but the level of profits will be normal.
- In the long run, LAR = LMR = P = LMC = LAC and there will be optimum allocation of resources.

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

Feature of the monopoly market:

A Single Seller: Monopoly means a single seller. It may be a person of a group of persons united together
in the form of cartels, pools, trusts, syndicates, associations etc., For example: OPEC (Organization of
petroleum exporting countries). This monopolist will have to complete control over the supply of his
products. Hence, monopoly market is known as “One firm industry”.

No close substitutes: There will be no close substitutes for the products of the monopolist. No other firm
in an industry will be producing a similar product. The cross elasticity of demand for the monopolist product
is zero. The consumer will not have any other alternatives under monopoly. Hence in Monopoly, there will
be absence of competition.
He is the price-maker: The Monopolist is the price-maker. He decides the price of his good or service.
Since he is the only seller and there is no close substitute. Hence he decides the price. The consumers are
either to buy the goods and services at the price fixed by the monopolist or to go without it. A monopolist has
dual power – both a price maker and output adjuster. But he cannot exercise both these powers
simultaneously / together, as he has no control over the market demand.

Price discrimination: A monopolist in order to attract all range of consumers, practices price
discrimination. Charging different prices to the different buyers for a similar kind of product is called as price

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discrimination. For example: A doctor may charge Rs. 250 for richer patients and Rs. 100 for poorer patients
for the same treatment.

Entry barriers: The entry of other firm is highly restricted in monopoly market situation. Some of the
important factors which acts as entry barriers are:

Natural factors: The nature itself has differentiated in allocating resources. For example: petroleum
products are available only in Arab countries. Jute can grow only in West Bengal.

Legal restrictions: Some companies through Law, posses the monopoly. For example: Possessing Patents,
Trademarks and Copyrights etc. The reasons to issue these is to encourage innovations and creativity.

Business formation: Some business firms through forming business organizations like Cartels, Pools,
Syndicates, Trusts creates monopoly markets.

Investment factors: Some large players through their massive investments create monopoly. For instance:
TATA and MITTAL have made huge investments in the production of iron and steel. Any new firm wants to
enter in that field, will not be able to invest on par with them.

Existence of super normal profit:

In monopoly, the seller always enjoys the super-normal profit. The price charged by him will always be more
than the cost of production. Hence, he always enjoys the super-normal profit.

Monopoly power: It is the power of seller in setting the price in the market. Monopoly power is influenced
by the following characters:
- Barrier to entry
- Degree of product differentiation
- Number of competitors
Pure monopoly is rare because it is abstract to say that a thing has no substitutes. Generally, everything has
a substitute – may be close or remote.

Types of monopoly:
Perfect monopoly: It is the kind of monopoly where only one seller operates in the market with having no
close substitutes. Here there is absolutely no competition. This type of monopoly in real market is very rare.

Simple monopoly: Here also single seller operates through the market with no close substitutes. But, some
remote substitutes can be found in the market. Here, seller will have very small competition.

Discriminating monopoly: Here the monopolist charges different price to different consumers for the
same product. It prevails in more than one market.

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Monopolist’s Revenue Curves:

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

- In order to increase the sales, a firm is reducing its price. Hence AR

falls.
- As a result of fall in price, total revenue increases but at a diminishing
rate.
- Total Revenue will be highest when Marginal revenue is zero.
- Total Revenue falls when Marginal revenue becomes negative.
- Average Revenue and Marginal Revenue both declines but fall in
Marginal revenue is greater than fall in Average Revenue.
- The Average Revenue curve of the firm and the demand curve of the
buyer is one and same. It slopes downwards from left to right indicating that the seller can sell larger
quantities only at reduced prices.

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- The Marginal Revenue curve is similar to that of Average Revenue curve. But Marginal revenue is less
than Average Revenue. It lies below the Average
Revenue curve, which is half way between Average
revenue curve and the Y axis, i.e., it cuts the horizontal
line between Y axis and AR into two equal parts.
- Average Revenue cannot be zero but Marginal
Revenue can be zero or even negative.
- If the seller wishes to charge Rs. 11, he can’t sell any
unit alternatively, if he wishes to sell 7 units, his price
can’t be higher than Rs. 4.

e−1
MR = AR x Where e = price elasticity of Demand
e
1−1
If e = 1, MR = AR x =0 if e > 1, Marginal revenue
1

will be positive.
If e < 1, Marginal revenue
will be negative.
In a straight line demand curve, we know that the elasticity
of the middle point is equal to one. If follows that Marginal
revenue corresponding to the middle point of the demand curve (AR curve) will be zero.
Thus,
If e =1, Total revenue is maximum and MR = 0
If e < 1, Total revenue is falling and MR is negative
A profit maximizing monopolist will never choose to sell output for which demand is relatively inelastic
because his total revenue will fall and marginal revenue will be negative. It will not be profitable for him to
produce beyond the midpoint on the demand curve.
Equilibrium of monopoly firm:
In case of monopoly, the price output equilibrium is that level of
price charged and output produced which gives maximum profit
to the monopolist or which minimizes his losses. The condition
for equilibrium in a monopoly market is the same as in other
markets:
- MC = MR
- MC curve must cut MR curve from below
The diagram shows that MC curve cuts MR curve at point E. At
E, the equilibrium price is OP and the equilibrium output is OQ.

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Short run equilibrium:

Under short run, when a firm is in equilibrium position, the firm may earn super normal profits, normal
profits or incur losses. To determine this, we introduce an AC curve. The below diagram illustrates the
concept.

Normal Profits:
When the firm only meets its average cost (AC), it earns normal profits and normal profit is also included in
average total cost. Normal profit is the normal rate of return on capital and remuneration for the risk bearing
factor of an entrepreneur. It is also called as break-even point. The diagram shows that MR = MC at E. The
equilibrium output is OQ. Since AR = AC, the firm earns normal profits.

Super Normal Profits:

To earn super normal profits, AR > ATC. In the diagram, MC cuts MR
at E to give the equilibrium output OQ which can be sold at
equilibrium pride OP. At OQ, the cost per unit is BQ. Therefore, in
equilibrium position, by fixing its price as OP and output as OQ, the
firm makes supernormal profit per unit equal to AB or total profit
equal to PABC.

Losses:
Nothing guarantees that a monopolist will earn profit. It all
depends upon his demand and cost conditions. If the monopolist
faces a very low demand for his product and his cost conditions
are such that AC > AR, he will not be making profit, but incurring
a loss.
In the diagram, MC cuts MR at E, the point of loss minimization.
At E, the equilibrium output is OQ and the equilibrium price is
OP. the cost corresponding to OQ is QA. QA is greater than
revenue per unit i.e., BQ. Thus, the monopolist incurs losses to
the extent of AB per unit or the total loss is PCAB, the shaded area
in the diagram.

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Long run equilibrium:

In the long run, a monopolist can adjust his plant size or use
the existing plant at any level so that he maximises his
profits. The monopolist need not produce at the optimum
level because of absence of competition. Therefore, he need
not reach the minimum of LAC curve. On the other hand, he
can stop at the point where his profits reaches maximum.
The monopolist will continue to make super normal profits
in the long run as the entry of new firm is restricted.

Discriminating monopoly:
Sometimes the monopolists charges different prices for different buyers for the same product, which is not
justified by cost differences. It is known as Price Discrimination. Discriminating price is more profitable than
a single uniform price. There are three types of Price discrimination.

First degree price discrimination:

In this stage consumers are charged the maximum price that they are willing to pay. Different consumers
have different preferences and levels of purchasing power and thus the amount they would be willing to pay
for a good often exceeds a single competitive price. Hence there will be no consumer surplus.
Example: Road-side seller of fruit.

Second degree discrimination:

Here the price charged is different to different consumers depending upon quantity purchased. In this case
the seller charges a higher per-unit price for fewer units sold and a lower per-unit price for larger quantities
purchased.
Example: Usage of electricity

Third degree discrimination:

Here the different price is charged to different group of people. This type of discrimination is possible only
when the firm is able to segment its customers into different groups. Each market is defined by unique
characteristics.

Conditions for price-discrimination:

a) The seller should have monopoly power to discriminate the price.
b) The seller should be able to segregate the market into different sub-markets.
c) The price elasticity of the product should be different in different markets.
d) It should not be possible for the buyers of the low priced market to resell the products to the buyers of the
high priced market.

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Price-output determination under price discrimination:

Let us suppose there are two markets- Market A and Market B to which a price discriminating monopolist
has to sell his products. Both markets have different price elasticities i.e., Market A – inelastic demand and
Market B – elastic demand.

The diagram shows Da and Db as the Average Revenue curves. MRa and MRb are the Marginal revenue
curves of the respective markets. Since all output is under one organization in Monopoly, there is only one
Marginal Cost Curve. TMR is the total Marginal Revenue curve. It is a lateral summation of the two curves
MRa and MRb. The twin conditions for equilibrium (i) MC = TMR (ii) MC = MRa = MRb

The discriminating monopolist not only has to decide how much to produce but also has to decide the output
in two sub-markets. In such a way and such a price that he maximizes his profits. In the diagram MC and
TMR interest at E. OM is the total output of the monopolist. EM is line of equal of MR. it indicates OM is sold
in market A at P1 price. OM2 is sold in market B at P2 price. Under this arrangement the MC of the total
output EM is equal to MR in cash separate market.
Thus the discriminating monopolist charges a higher price from the market which has in-elastic demand and
charges a lower price from the market which has elastic demand. To conclude, the monopolist benefits from
both the markets. A monopolist charges a higher price from the market which has a relatively
inelastic demand.

Thus, we see that the marginal revenues in the two markets are different when the elasticity of demand at a
single price is different. Also, the MR in the market in which elasticity is high i.e., market B, is greater than
the MR of the market where the elasticity is low i.e. market A. Now, it is profitable for the monopolist to
transfer some quantity of the product from A to B. We see that the monopolist is now discriminating between
markets A and B. the monopolist continues to transfer units from A to B upto a point when the MR in the two
markets become equal. After this, the monopolist will charge different prices in the markets, that is, higher
price in market A which has lower elasticity of demand.

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Objectives of price discrimination:

- To earn maximum profit
- To dispose off surplus stock
- To enjoy economies of scale
- To capture foreign markets
- To secure equity through pricing

Monopolistic competition:
In real life perfect competition and monopoly are rarely found. What we find in real life is a mixture of two
markets, namely Monopolistic competition. The concept of monopolistic competition was introduced by Prof.
E. H. Chamberlin of U. S. A in his famous book ‘The Theory of Monopolistic Competition’.

Monopolistic competition market situation is a peculiar blend or combination of both Monopoly and Perfect
Competition. It is a market situation where a group of monopolists are in competition. Hence in this kind of
market situation “Large numbers of small sellers are selling differentiated products which are close but not
perfect substitutes”. For example: Market for soaps and detergents, cosmetics, clothing industry etc.

The feature of monopolistic competition:

Existence of large number of firms: In Monopolistic competition, the number of firms producing a
product will be large, but the size of each firm will be small. Each firm follows an independent price-output
policy. No firm’s action influences the other in any significant manner.
Product differentiation: In monopolistic competition, by adopting different techniques one firm will be
trying to show that its products are different from other firm. Those different techniques may be in the form
of: (a) differences in the quality of raw materials used (b) offering supplementary and other services to
consumer like offering gifts, free home delivery, after sales services etc.

Free entry and exit forms: New firms will have complete freedom to enter into an industry to leave the
industry. There will be no entry barriers and in the same no restriction on coming out of the industry like in
the perfect competition.

It is a combination of monopoly and competition: Monopolistic competition is a peculiar

combination of both monopoly and competition. Large number of small sellers producing differentiated
products which are close substitutes but can’t be perfect substitutes. A small group of monopolists are in
competition to sell their goods.

Selling costs: All those expenses, which are incurred on sales promotion of a product are called as selling
costs. These selling costs includes cost or advertisements, free gifts, decoration of shop, demonstrations etc.
All these costs are necessary for the sales promotion because many sellers are selling products which are close
substitutes. So to induce buyers to buy their products selling costs are necessary.

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Definite preference of the consumers: The consumers will have definite preference for a particular
product, due to its special features. But sometimes the demand curve in the monopolistic competition will be
more elastic. It implies that a small increase in prices the demand may be reduced drastically. Hence, in
monopolistic competition, the sellers complete with each other through product differentiate or selling, but
not with price.

Price-output determination in monopolistic competition:

Under monopolistic competition, the firm will be in equilibrium position when marginal revenue is equal to
marginal cost. So long the marginal revenue is greater than marginal cost, the seller will find it profitable to
expand his output, and if the MR is less than MC, it is obvious he will reduce his output where the MR is equal
to MC. In short run, therefore, the firm will be in equilibrium when it is maximizing profits, i.e., when MR =
MC. Since the goods sold are differentiated and the concept of uniform pricing does not prevail, each firm is
a price maker and is in a position to determine the price of its own product. Thus, the demand curve of the
firm is downward sloping. Generally, the less differentiated the product is from its competitors, the more
elastic the curve will be.

Conditions for equilibrium of an individual firm

- MC = MR
- MC curve must cut MR curve from below
Both, AR and MR curves are downward sloping. It is the position of the AC curve that helps to know whether
the firm is making profits or incurring losses.

Short term equilibrium: Under short run, when a monopolistic

firm is in equilibrium position, it may earn super profits, normal
profits or incur losses.
To earn super normal profits, AR must be greater than AC. In the
diagram, the MC curve cuts the MR curve at E given equilibrium
output as OM and the equilibrium price as OP. At equilibrium, the
total revenue (OPQM) > total cost (ORSM). Hence, in the short –
run, the firm earns total profit of RPQS which is the shaded area in
the diagram.

The monopolistic competitor can incur losses in the short run. If AR

< AC, then firm will incur losses. In the diagram, the MC curve cuts
MR curve at E to give equilibrium output as ON and the equilibrium
price as OT. At equilibrium, the total revenue (OTKN) < total cost
(OGHN). Hence, in the short run, the firm incurs a loss indicated by
TGHK the shaded area in the diagram.

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When the firm only meets its Average Cost (AC), it earns normal profits and normal profit is also included in
Average Total Cost. Normal profit is the normal rate of return on capital and remuneration for the risk bearing
factor of an entrepreneur. It is also called as break-even point. The diagram shows that MR = MC at E. The
equilibrium is OQ. Since AR = AC, then firm earns normal profits.

Long run equilibrium of the firm under monopolistic competition:

In the long run, all the existing firms will earn normal profits. If the existing firms earn super normal profits,
the entry of new firms will reduce its share in the market. The Average Revenue of the product will come
down. Hence, the size of the profit will be reduced. If the existing firms incur losses in the long-run, some of
the firms will leave the industry, thus increasing the share of the existing firms in the market. This will reduce
the cost of production, which will in turn increase the profit earned by the existing firms.

The AR curve touches the LAC curve at point corresponding

to this point, the quantity is Q and the price is P. At
equilibrium, LMC = MR and all the firms only earn normal
profits.

An individual firm in the long run is in equilibrium position

when it produces a quantity lower than its full capacity level
i.e. excess capacity. In the above diagram, the firm could
expand its output from Q to R and reduce the Average Cost.
But, it is not doing so because it would reduce the AR even
more than AC.

Oligopoly: Oligopoly is an important form of imperfect competition. It is often described as ‘competition

among a few’. When there are a few sellers in a market, oligopoly is said to exist.
Prof. Stigler defines oligopoly as “that situation in which a firm bases its market policy in part on the expected
behaviour of a few close rivals”.
Example: Cold drink industry, automobile industry

Types of oligopoly:
Pure/perfect and differentiated/imperfect oligopolies. Pure oligopoly is when the product is homogeneous in
nature.
Example: Aluminium industry
Differentiated or imperfect oligopoly is based on product differentiation. Example – automobile industry.

Open and closed oligopolies:

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

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Collusive and competitive oligopolies:

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

Partial or full oligopolies:

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

Partial or full oligopolies:

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

Characteristics of oligopoly:
A few sellers: Oligopoly comprises of a few sellers. It is different form monopoly which has one seller,
monopolistic competition which has many sellers and perfect competition which has many sellers and perfect
competition which has innumerable sellers.

Interdependence: There exists a close interdependence among firms. A single firm cannot take
independent decisions without considering the rivals’ reactions. This is because, if the oligopolist lowers the
price, his rivals will also lower their prices. On the other hand, if he increases the price, the rivals will not,
and therefore, he will lose customers.

Selling costs and advertisement: Under oligopoly, rival firms employ aggressive and defensive
marketing weapons. The purpose of this is to gain a greater share in the market or to maximize its profits and
minimize its losses. Firms incur expenditure on advertising a sales promotion measures. The rivalry is related
to non-price factors only. The objective of an oligopolist is not necessarily to maximize profit. It is to capture
a larger part in the share of the market.

Group behaviour: Firms may realise the importance of mutual cooperation. They will have a tendency of
collusion. At the same time, the desire of each firm to earn maximum profit may encourage competitive spirit.
Thus, co-operative and collusive trend as well as competitive trend would prevail in an oligopolistic market.

Price rigidity: Another important feature of oligopoly is price rigidity. Price is sticky or rigid at the
prevailing level due to the fear of reaction from the rival firms. If an oligopolistic firm lowers its price, the
price reduction will be followed by the rival firms. As a result, the firm loses its customers. Expecting the same
kind of reaction, if the oligopolistic firm raises the price, the rival firms will not follow. This would result in
losing customers. In both ways, the firm would face difficulties. Hence, the price is rigid.

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Price and output decisions in an oligopolistic market:

This can be explained by kinked demand cure hypothesis.
Price, in many oligopoly industries, remains sticky and inflexible for a long time. The explanation for this
price rigidity under oligopoly is the kinked demand curve hypothesis given by an American economist, Paul
Sweezy.
Examples: Automobiles, steel, etc.
- If an industry is composed of few firms each selling identical or homogeneous products and having
powerful influence on the total market, the price and output policy of each is likely to affect the other
appreciably, therefore they will try to promote collusion.
- In case there is product differentiation, an oligopolistic can raise or lower his price without any fear of
losing customers or of immediate reactions from his rivals. However, keen rivalry among them may create
condition of monopolistic competition.

Kinked Demand Curve: It is the bending in the demand curve as

a result of decrease in the price of the competitors to match each
others. A kinked demand cur e has a ‘kink’ at point K as shown in the
following diagram.

Each oligopolistic believes that if the lowers the price, his rivals will
also lower their prices. Thus, the upper portion of the demand curve
is price elastic. If he increases the price, the rivals will not and
therefore, he will lose customers. This explains the inelastic lower
portion of the demand curve. Each oligopolistic will thus adhere to
the prevailing price seeing no gain in changing it and a kink will be formed at the prevailing price.
Here the prices are determined in the following way:

Interdependent pricing: Here sometimes the firms ignore interdependence. When it disappears demand
curve facing the oligopoly becomes determined.

Price wars: Here the firms are able to predict the counter moves of their rivals. This is how price war starts
in determining price.

Price leadership: Here all the firms accept one firm as a leader and other follows it in setting the price. The
leadership will come from dominant firm.

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Business Cycle

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

Phases of Business Cycle

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

Figure1 Phases of Business Cycle

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Expansion: The expansion phase is characterised by increase in national output, employment, aggregate
demand, capital and consumer expenditure, sales, profits, rising stock prices and bank credit. This state
continues till there is full employment of resources and production is at its maximum possible level using the
available productive resources. There is altogether increasing prosperity and people enjoy high standard of
living due to high levels of consumer spending, business confidence, production, factor incomes, profits and
investment. The growth rate eventually slows down and reaches its peak.

Peak: The term peak refers to the top or the highest point of the business cycle. In the later stages of
expansion, inputs are difficult to find as they are short of their demand and therefore input prices increase.
Output prices also rise rapidly leading to increased cost of living and greater strain on fixed income earners.
Consumers begin to review their consumption expenditure on housing, durable goods etc. Actual demand
stagnates.

Contraction: The economy cannot continue to grow endlessly. As mentioned above, once peak is reached,
increase in demand is halted and starts decreasing in certain sectors. During contraction, there is fall in the
levels of investment and employment. Producers do not instantaneously recognise the pulse of the economy
and continue anticipating higher levels of demand, and therefore, maintain their existing levels of investment
and production. The consequence is a discrepancy or mismatch between demand and supply. Supply far
exceeds demand. Initially, this happens only in few sectors and at a slow pace, but rapidly spreads to all
sectors. Producers being aware of the fact that they have indulged in excessive investment and over
production, respond by holding back future investment plans, cancellation and stoppage of orders for
equipments and all types of inputs including labour. This in turn generates a chain of reactions in the input
markets and producers of capital goods and raw materials in turn respond by cancelling and curtailing their
orders. This is the turning point and the beginning of recession.
Decrease in input demand pulls input prices down; incomes of wage and interest earners gradually decline
resulting in decreased demand for goods and services. Producers lower their prices in order to dispose off
their inventories and for meeting their financial obligations. Consumers, in their turn, expect further
decreases in prices and postpone their purchases. This process gathers speed and recession becomes severe.

Trough and Depression: Depression is the severe form of recession and is characterized by extremely
sluggish economic activities. During this phase of the business cycle, growth rate becomes negative and the
level of national income and expenditure declines rapidly. Demand for products and services decreases,
prices are at their lowest and decline rapidly forcing firms to shutdown several production facilities. Since
companies are unable to sustain their work force, there is mounting unemployment which leaves the
consumers with very little disposable income. A typical feature of depression is the fall in the interest rate.
With lower rate of interest, people’s demand for holding liquid money (i.e. in cash) increases.

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Recovery: The economy cannot continue to contract endlessly. It reaches the lowest level of economic
activity called trough and then starts recovering. Trough generally lasts for some time and marks the end of
pessimism and the beginning of optimism. This reverses the process. The process of reversal is initially felt
in the labour market. The spurring of investment causes recovery of the economy. This acts as a turning point
from depression to expansion. As investment rises, production increases, employment improves, income
improves and consumers begin to increase their expenditure. Increased spending causes increased aggregate
demand and in order to fulfil the demand more goods and services are produced.

Examples of Business Cycles

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

Information Technology bubble burst of 2000: Information Technology (IT) bubble or Dot.Com
bubble roughly covered the period 1997-2000. During this period, many new Internet–based companies
(commonly referred as dot-com companies) were started. The low interest rates in 1998–99 encouraged the
start-up internet companies to borrow from the markets. Due to rapid growth of internet and seeing vast
scope in this area, venture capitalists invested huge amount in these companies. Due to over- optimism in
the market, investors were less cautious. There was a great rise in their stock prices and in general, it was
noticed, that companies could cause their stock prices to increase by simply adding an "e-" prefix to their
name or a ".com" to the end. These companies offered their services or end products for free with the
expectation that they could build enough brand awareness to charge profitable rates for their services later.
As a result, these companies saw high growth and a type of bubble developed. The "growth over profits"
mentality led some companies to engage in lavish internal spending, such as elaborate business facilities.
These companies could not sustain long. The collapse of the bubble took place during 1999–2001. Many dot-
com companies ran out of capital and were acquired or liquidated. Nearly half of the dot –com companies
were either shut down or were taken over by other companies. Stock markets crashed and slowly the
economies began feeling the downturn in their economic activities.

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Recent Example of Business Cycle: Global Economic Crisis (2008-09): The recent global economic
crisis owes its origin to US financial markets. Following Information Technology bubble burst of 2000, the
US economy went into recession. In order to take the economy out of recession, the US Federal Reserve (the
Central Bank of US) reduced the rate of interest. This led to large liquidity or money supply with the banks.
With lower interest rates, credit became cheaper and the households, even with low creditworthiness, began
to buy houses in increasing numbers. Increased demand for houses led to increased prices for them. The
rising prices of housing led both households and banks to believe that prices would continue to rise. Excess
liquidity with banks and availability of new financial instruments led banks to lend without checking the
creditworthiness of borrowers. Loans were given even to sub-prime households and also to those persons
who had no income or assets. Houses were built in excess during the boom period and due to their oversupply
in the market, house prices began to decline in 2006. Housing bubble got burst in the second half of 2007.
With fall in prices of houses which were held as mortgage, the sub - prime households started defaulting on
a large scale in paying off their instalments. This caused huge losses to the banks. Losses in banks and other
financial institutions had a chain effect and soon the whole US economy and the world economy at large felt
its impact.

Features of Business Cycles

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

Business Cycles may occur due to external causes or internal causes or a combination of both. The 2001
recession was preceded by an absolute mania in dot-com and technology stocks, while the 2007-09 recession
followed a period of unprecedented speculation in the U.S. housing market.

Internal Causes: The Internal causes or endogenous factors which may lead to boom or bust are:

Fluctuations in Effective Demand: According to Keynes, fluctuations in economic activities are

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

Thus, increase in aggregate effective demand causes conditions of expansion or boom and decrease in
aggregate effective demand causes conditions of recession or depression. (You will study about these concepts
in detail at Intermediate level in Economics for Finance.

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

Variations in government spending: Fluctuations in government spending with its impact on aggregate
economic activity result in business fluctuations. Government spending, especially during and after wars, has
destabilizing effects on the economy.

Macroeconomic policies: Macroeconomic policies (monetary and fiscal policies) also cause business
cycles. Expansionary policies, such as increased government spending and/or tax cuts, are the most common
method of boosting aggregate demand. This results in booms. Similarly, softening of interest rates, often
motivated by political motives, leads to inflationary effects and decline in unemployment rates. Anti-
inflationary measures, such as reduction in government spending, increase in taxes and interest rates cause
a downward pressure on the aggregate demand and the economy slows down. At times, such slowdowns may
be drastic, showing negative growth rates and may ultimately end up in recession.
Money Supply: According to Hawtrey, trade cycle is a purely monetary phenomenon. Unplanned changes
in supply of money may cause business fluctuation in an economy. An increase in the supply of money causes
expansion in aggregate demand and in economic activities. However, excessive increase of credit and money

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also set off inflation in the economy. Capital is easily available, and therefore consumers and businesses alike
can borrow at low rates. This stimulates more demand, creating a virtuous circle of prosperity. On the other
hand, decrease in the supply of money may reverse the process and initiate recession in the economy.

Psychological factors: According to Pigou, modern business activities are based on the anticipations of
business community and are affected by waves of optimism or pessimism. Business fluctuations are the
outcome of these psychological states of mind of businessmen. If entrepreneurs are optimistic about future
market conditions, they make investments, and as a result, the expansionary phase may begin. The opposite
happens when entrepreneurs are pessimistic about future market conditions. Investors tend to restrict their
investments. With reduced investments, employment, income and consumption also take a downturn and
the economy faces contraction in economic activities.

External Causes: The External causes or exogenous factors which may lead to boom or bust are:

Wars: During war times, production of war goods, like weapons and arms etc., increases and most of the
resources of the country are diverted for their production. This affects the production of other goods - capital
and consumer goods. Fall in production causes fall in income, profits and employment. This creates
contraction in economic activity and may trigger downturn in business cycle.

Post War Reconstruction: After war, the country begins to reconstruct itself. Houses, roads, bridges etc.
are built and economic activity begins to pick up. All these activities push up effective demand due to which
output, employment and income go up.

Technology shocks: Growing technology enables production of new and better products and services.
These products generally require huge investments for new technology adoption. This leads to expansion of
employment, income and profits etc. and give a boost to the economy. For example, due to the advent of
mobile phones, the telecom industry underwent a boom and there was expansion of production, employment,
income and profits.

Natural Factors: Weather cycles cause fluctuations in agricultural output which in turn cause instability in
the economies, especially those economies which are mainly agrarian. In the years when there are draughts
or excessive floods, agricultural output is badly affected. With reduced agricultural output, incomes of farmers
fall and therefore they reduce their demand for industrial goods. Reduced production of food products also
pushes up their prices and thus reduces the income available for buying industrial goods. Reduced demand
for industrial products may cause industrial recession.

Population growth: If the growth rate of population is higher than the rate of economic growth, there will
be lesser savings in the economy. Fewer saving will reduce investment and as a result, income and
employment will also be less. With lesser employment and income, the effective demand will be less, and
overall, there will be slowdown in economic activities.

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Relevance of Business Cycles

Business cycles affect all aspects of an economy. Understanding the business cycle is important for businesses
of all types as they affect the demand for their products and in turn their profits which ultimately determines
whether a business is successful or not. Knowledge regarding business cycles and their inherent
characteristics is important for a businessman to frame appropriate policies. For example, the period of
prosperity opens up new and superior opportunities for investment, employment and production and thereby
promotes business. In contrast, a period of recession or depression reduces business opportunities and
profits. A profit maximising firm has to consider the nature of the economic environment while making
business decisions, especially those related to forward planning.

Business cycles have tremendous influence on business decisions. The stage of the business cycle is crucial
while making managerial decisions regarding expansion or down-sizing. Businesses have to advantageously
respond to the need to alter production levels relative to demand. Different phases of the cycle require
fluctuating levels of input use, especially labour input. Firms should exercise the capability to expand or
rationalize production operations so as to suit the stage of the business cycle. Business managers need to
work effectively to arrive at sound strategic decisions in complex times across the whole business cycle,
managing through boom, downturn, recession and recovery.

Economy-wide trends can have significant impact on all types businesses. However, it should be kept in
mind that business cycles do not affect all sectors uniformly. Some businesses are more vulnerable to changes
in the business cycle than others. Businesses whose fortunes are closely linked to the rate of economic growth
are referred to as "cyclical" businesses. These include fashion retailers, electrical goods, house-builders,
restaurants, advertising, overseas tour operators, construction and other infrastructure firms. During a boom,
such businesses see a strong demand for their products but during a slump, they usually suffer a sharp drop
in demand. It may also happen that some businesses actually benefit from an economic down turn. This
happens when their products are perceived by customers as representing good value for money, or a cheaper
alternative compared to more expensive products.

Overcoming the effects of economic downturns and recessions is one of the major challenges of sustaining a
business in the long-term. The phase of the business cycle is important for a new business to decide on entry
into the market. The stage of business cycle is also an important determinant of the success of a new product
launch. Surviving the sluggish business cycles require businesses to plan and set policies with respect to
product, prices and promotion.

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