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Chapter 1: Introduction to Business Economics

What is Economics?
 The term “Economics” owes its origin to the Greek word “Oikonomia”
which Means “household”.
 Till 19th century, Economics was known as “ Political Economy ”.
 The book named “ An inquiry into the nature and causes of the wealth of
nations” (1776) usually abbreviated as “The Wealth of Nations” by Adam
Smith is Considered as the first modern work of economics.
 Economics is the study of the process by which the relatively scarce
resources are allocated to satisfy the competing unlimited wants of
human beings in a society.
 Economics is, thus the study of how we work together to transform the
scare Resources into goods and services to satisfy our infinite wants and
how we distribute it.
 This definitions of economics, with the narrow focus on using the
relatively scare Resources to satisfy human wants, is the domain of
modern new classical micro Economic analysis.
 It is incomplete as its brings to our mind the picture of a society with
fixed Resources, skill and productive capacity.
 These two fundamental facts that:
 Human beings have unlimited wants;
The means to satisfy the unlimited wants are relatively scare form
the subject matter of economics.

Meaning of Business Economics.

 Business Economics has close connection with economic theory (micro as
well as macro economic).
 Operations Research, Statistics, Mathematics and the theory decision
making.
 Business Economics is not only valuable to business decision maker, but
also useful for managers of 'not-for- profit' organization.
 Business Economics may be defined as the use of economic analysis to
make business decisions involving the best use of an organisation'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.

Subject Matter of Economics:

Economics has been broadly divided into two major parts.
 Micro Economics
 Macro Economics

Micro Economics:
 It is basically the study of the behavior of different individuals and
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organisations with an economic system.
 Micro Economics examines how the individual units (consumers or firms)
make decisions as to how to efficiently allocate their scare resources.

Mainly study the following in Micro Economics:

 Product pricing;
 Consumer behavior;
 Factor pricing;
 The economic conditions of a section of people;
 Behaviour of firms;
 Location of industry.

Macro Economics:
 It is the study of the overall economic phenomena or the economy as a
whole, rather then its individual parts.
 The behavior of the large economic aggregates, such as, the overall levels
of output, total consumption, total saving and total investment and also
how these aggregated shift overtime.

A few areas that come under Macro Economics:

 National Income and National output.
 The general price level and interest rates.
 Balance of trade and balance of payments.
 External value of currency.
 The overall level of savings and investment.
 The level of employment and rate of economic growth.

Nature of Business Economics:

 Business Economics is a science:
It is systematised body of knowledge which establishes cause and effect
relationships.
Business Economics integrates the tools of decision science such as
mathematics, statistics and econometrics with economic theory to arrive
at appropriate strategies for achieving the goals of the business
enterprises.

 Based 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 organisation.

 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.

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 Business Economics is an art as it involves practical application of rules

and principle for the attainment of set objectives.

 Use of theory of markets and private enterprises:

 Business Economics largely use the theory of markets and private
enterprises.
 It uses the theory of the firm and resource allocation in the back drop of a
private enterprises economy.

 Pragmatic in Approach:
Micro Economics is abstract and purely theoretical and analysis
economic phenomena under unrealistic assumptions whereas business
economics is pragmatic as it tackles practical problems.

 Interdisciplinary in nature:
Business Economics is interdisciplinary in nature incorporates tools from
other disciplines such as mathematics, operation, research management
theory, accounting marketing.

 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 manners but it does not involve
any value judgement.
 A Normative Science involves value judgements.
 It is prescriptive in nature and suggests "what should be" a particular
course of action under given circumstances.

Scope of Business Economics

The scope of Business Economics is quite wide.
There are two categories of business issues to which economic theories.
 Microeconomics applied to operational or internal issues.
 Macroeconomics applied to environmental or external issues.

Microeconomics applied to Operational/Internal Issue

 Operational issues include all those 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, products decisions,
technology and factor combinations are a few example of operational
issues.

The following Microeconomic theories deal with most of these issues:

 Demand analysis and forecasting:
 Demand analysis pertains to the behavior of Consumers in the market. It
studies the nature of consumer preferences and the effect of changes in
the determinants of demand such as, price of commodity, consumer's
income etc..
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 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.

 Production and Cost Analysis:

 Production theory explains the relationship between input and output.
business economist has to decide on the optimum size of output, given
the objectives of the firm.
 A He has also to ensure that the firm is not incurring undue cost.
 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.

 Inventory Management:
 Inventory Management theories pertain to rules that firms can use to
minimize the cost associated with maintaining inventory in the form of
"work-in- process" raw materials and finished goods.
 Inventory policies affect the profitability of the firm.

 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.
 Which the firm commands and the Strategies to be followed in market
management under the given competitive conditions such as, product
design and marketing.

 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.

 Theory of capital and investment Decisions:

 For maximizing its profits, the firm has to carefully evaluate its
investment decision 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 efficient of capital.

 Profit Analysis:
 Profits are, most often, uncertain due to changing prices, market
conditions.
 Profit theory guides the firm in the measurement and management of
profits under conditions of uncertainty.

 Risk and uncertainty Analysis:

 Business firms generally operate under conditions of risk and
uncertainty.
 Analysis of risks and uncertainties help the business firm in arriving at
efficient decision and in formulating plans on the basis of past data.
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Macro Economics applied to Environmental or External Issues

The major macro-economic factors relate to:
 The type of economic system.
 State of business cycle.
 The general trends in national income, employment, prices saving and
 investment.
 Government economic policies like industrial policy, competition policy,
monetary and fiscal policy.
 Working of financial sector and capital market.
 Socio-economic organisations like trade union, producer and consumer
unions.

Basic problems of an Economy

 Economic system, be it capitalist, socialist or mixed, has to deal with this
central problem of scarcity of resources relative to the wants for them.
 This is generally called "the central economic problem".
 The central economic problem it further divided into four basic economic
problems these are:
 What to produce.
 How to produce.
 For whom to produce.
 What provision (if any) are to be made for economic growth.

What provision should be made for economic growth:

 A society would not like to use all its scarce resources for current
consumption only.
 This is because, if it uses all the resources for current consumption and
no provision is made for future production the society's production
capacity would not increase.
 Their implies that incomes or standards of living of the people would
remain stagnant and in future, the levels of living may actually decline.

"Economic System"
 An economic system refer to the sum total of arrangements for the production
and distribution of goods and services in a society.

 These are:
 Capitalist Economy
 Socialist Economy
 Mixed Economy

Capitalist economy
 Capitalism, the predominant economic system in the modern global
economy, is an economic system in which all means of production are
owned and controlled by private individual for profit
 Some examples of a capitalist economy may include U.S., U.K., Germany,
Japan, Mexico, Singapore etc.
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 However, many of them are not pure form of capitalism but show some
features of being a capitalist economy.
 An economy is called capitalist or a free market economy or laissez- faire
economy.

Characteristics of Capitalist Economy:

 Right to private property:
 The right to private property means that productive factor such as land,
factories, machines; mines etc. can be under private ownership.
 The government may however, put some restriction for the benefits of the
society in general.

 Freedom of enterprise:
Each individual, whether consumer, producer or resource owner, is free
to engage in any type of economic activity, for example, a producer is free
any type of firm and produce goods and services of his choice.

 Freedom of economic choice:

All individuals are free to make their economic choice, regarding
consumption, work, production exchange etc.

 Profit motive:
 Profit motive is the driving force in a free enterprise economy and directs
all economic activities.
 Desire for profits includes entrepreneurs to organize production so as to
earn maximum profits.

How do Capitalist Economies Solve their Central Problem

 A capitalist economy has no central planning authority to decide what,
how and for whom to produce.
 In the absence of any central authority, it looks like a miracle as to how
such an economy function.
 If the consumers want cars and producers choose to make cloth and
workers choose to work for the furniture industry, there will be total
confusion and chaos in the country.
 Such an economy uses the impersonal forces of market demand and
supply or the price mechanism to solve its central problems.

 What to Produce?
 Deciding 'what to produce' The aim of an entrepreneur is to earn as much
profits as possible.
 This causes businessmen to compete with one another to produce those
goods which consumers wish to buy.
 Thus, if consumers want more cars, there will be an increase in the
demand for cars and as a result their prices will increase.
 A rise in the price of cars, costs remaining the same, will lead to more
profits.
 This will induce producers to produce more cars. On the other hand, if
the consumers' demand for cloth decreases, its price would fall and
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profits would go down.
 Therefore, business firms have less incentive to produce cloth and less of
cloth will be produced.
 Thus, more of cars and less cloth will be produced in such an economy.
 In a capitalist economy (like the USA, UK and Germany) the question
regarding what to produce is ultimately decided by consumers who show
their preferences by spending on the goods which they want.

 Deciding about consumption, saving and investment

 Consumption and savings are done by consumers and investments are
done by entrepreneurs.
 Consumers' savings, among other factors, are governed by the rate of
interest prevailing in the market. Higher the interest rates, higher will be
the savings.
 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.
 The rate of interest on savings and the rate of return on capital are
nothing but the prices of capital.

Merits of Capitalist Economics:

 Capitalism is self-regulating and works automatically through price
mechanism. There is no need of incurring costs for collecting and
processing of information and for formulating, implementing and
monitoring policies.
 The existence of private property and the driving force of profit motive
result in greater efficiency and incentive to work.
 The process of economic growth is likely to be faster under capitalism.
This is because the investors try to invest in only those projects which are
economically feasible.
 Resources are used in activities in which they are most productive. This
results in optimum allocation of the available productive
 There is usually high degree of operative efficiency under the capitalist
system.
 Cost of production is minimized as every producer tries to maximize his
profit by employing methods of production which are cost-effective.
 Capitalist system offer incentives for efficient economic decisions and
their implementation.
 Consumers are benefitted as competition forces producers to bring in a
large variety of good quality products at reasonable prices. This, along
with freedom of choice, ensures maximum satisfaction to consumers.
This also results in higher standard of living.

Demerits of capitalism
 There is vast economic inequality and social injustice under capitalism.
Inequalities reduce the aggregate economic welfare of the society as a
whole and split the society into two classes namely the 'haves' and the
'have-nots', sowing the seeds of social unrest and class conflict.
 Under capitalism, there is precedence of property rights over human
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rights.
 Economic inequalities lead to wide differences in economic opportunities
and perpetuate unfairness in the society.
 The capitalist system ignores human welfare because, under a capitalist
set up, the aim is profit and not the welfare of the people.
 Due to income inequality, the pattern of demand does not represent the
real needs of the society.
 Exploitation of labour is common under capitalism. Very often this leads
to strikes and lock outs. Moreover, there is no security of employment.
This makes workers more vulnerable.
 Consumer sovereignty is a myth as consumers often become victims of
exploitation. Excessive competition and profit motive work against
consumer welfare.
 Capitalism leads to the formation of monopolies as large -rms may be
able to drive out small ones by fair or foul means.
 Excessive materialism as well as conspicuous and unethical consumption
lead to environmental degradation.

Capitalist economy
 Capitalism, the predominant economic system in the modern global
economy, is an economic system in which all means of production are
owned and controlled by private individual for profit
 Some examples of a capitalist economy may include U.S., U.K., Germany,
Japan, Mexico, Singapore etc.
 However, many of them are not pure form of capitalism but show some
features of being a capitalist economy
 An economy is called capitalist or a free market economy or laissez- faire
economy.

Socialist Economy
 The concept of socialist economy was propounded by Karl Marx and
Frederic Engels in their work 'The Communist Manifesto' published in
1848.
 In this economy, the material means of production i.e. factories, capital,
mines etc. are owned by the whole community represented by the State.
 All members are entitled to get benefit from the fruits of such socialised
planned production on the basis of equal rights.
 A socialist economy is also called as "Command Economy" or a "Centrally
Planned Economy".
 Here, the resources are allocated according to the commands of a central
planning authority and therefore, market forces have no role in the
allocation of resources.
 Under a socialist economy, production and distribution of goods are
aimed at maximizing the welfare of the community as a whole.

Some important characteristics of this economy are:

 Collective Ownership:
 There is collective ownership of all means of production except small
farms, workshops and trading -rms which may remain in private hands.
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 As a result of social ownership, profit motive and self-interest are not the
driving forces of economic activity as it is in the case of a market
economy.

 Economic Planning:
 There is a Central Planning Authority to set and accomplish socio-
economic goals; that is why it is called a centrally planned economy.
 The major economic decisions, such as what to produce, when and how
much to produce, etc., are taken by the central planning authority.

 Absence of Consumer Choice:

 Freedom from hunger is guaranteed, but consumers' sovereignty gets
restricted by selective production of goods.
 The range of choice is limited by planned production. However, within
that range, an individual is free to choose what he likes most.

 Relatively Equal Income Distribution:

 A relative equality of income is an important feature of Socialism.
 Among other things, differences in income and wealth are narrowed down
by lack of opportunities to accumulate private capital.

 Minimum role of Price Mechanism or Market forces:

 Price mechanism exists in a socialist economy; but it has only a
secondary role, e.g., to secure the disposal of accumulated stocks.
 Since allocation of productive resources is done according to a
predetermined plan, the price mechanism as such does not influence
these decisions.
 In the absence of the profit motive, price mechanism loses its
predominant role in economic decisions.
 The prices prevailing under socialism are 'administered prices' which are
set by the central planning authority on the basis of socio-economic
objectives.

 Absence of Competition:
 Since the state is the sole entrepreneur, there is absence of competition
under socialism.
 The erstwhile U.S.S.R. is an example of socialist economy.
 In today's world there is no country which is purely socialist.
 North Korea, the world's most totalitarian state, is another prominent
example of a socialist economy.
 Other examples include China and Cuba.

 Minimum role of Price Mechanism or Market forces:

 Price mechanism exists in a socialist economy; but it has only a
secondary role, e.g., to secure the disposal of accumulated stocks.
 Since allocation of productive resources is done according to a
predetermined plan, the price mechanism as such does not influence
these decisions.
 In the absence of the profit motive, price mechanism loses its
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predominant role in economic decisions.
 The prices prevailing under socialism are 'administered prices' which are
set by the central planning authority on the basis of socio-economic
objectives.

 Absence of Consumer Choice:

 Freedom from hunger is guaranteed, but consumers' sovereignty gets
restricted by selective production of goods.
 The range of choice is limited by planned production. However, within
that range, an individual is free to choose what he likes most.

 Relatively Equal Income Distribution:

 A relative equality of income is an important feature of Socialism.
 Among other things, differences in income and wealth are narrowed down
by lack of opportunities to accumulate private capital.

Merits of Socialism:
 Equitable distribution of wealth and income and provision of equal
opportunities for all help to maintain economic and social justice.
 Rapid and balanced economic development is possible in a socialist
economy as the central planning authority coordinates all resources in an
efficient manner according to set priorities.
 Socialist economy is a planned economy. In a socialistic economy, there
will be better utilization of resources and it ensures maximum
production. Wastes of all kinds are avoided through strict economic
planning. Since competition is absent, there is no wastage of resources
on advertisement and sales promotion.

Demerits of Socialism:
 Socialism involves the predominance of bureaucracy and the resulting
inefficiency and delays. Moreover, there may also be corruption, red
tapism, favouritism, etc.
 It restricts the freedom of individuals as there is state ownership of the
material means of production and state direction and control of nearly all
economic activity.
 Socialism takes away the basic rights such as the right of private
property.
 It will not provide necessary incentives to hard work in the form of profit.
 Administered prices are not determined by the forces of the market on the
basis of negotiations between the buyers and the sellers. There is no
proper basis for cost calculation. In the absence of such practice, the
most economic and scientific allocation of resources and the efficient
functioning of the economic system are impossible.
 State monopolies created by socialism will sometimes become
uncontrollable. This will be more dangerous than the private monopolies
under capitalism.

The Mixed Economy

 The mixed economic system depends on both markets and governments
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for allocation of resources.
 In fact, every economy in the real world makes use of both markets and
governments and therefore is mixed economy in its nature.
 In a mixed economy, the aim is to develop a system which tries to include
the best features of both the controlled economy and the market economy
while excluding the demerits of both.

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CHAPTER 2 - THEORY OF DEMAND AND SUPPLY

MEANING OF DEMAND
The term ‘demand’ refers to the quantity of a good or service that buyers are
willing and able to purchase at various prices during a given period of time.
For example, people may desire much bigger houses, luxurious cars etc. But
there are also constraints that they face such as prices of products and limited
means to pay. effective demand for a thing depends on (i) desire (ii) means to
purchase and (iii) willingness to use those means for that purchase.

Two things are to be noted about the quantity demanded.

i. The quantity demanded is always expressed at a given price. At different
prices different quantities of a commodity are generally demanded.
ii. The quantity demanded is a flow. 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’ i.e., one
thousand dozens of oranges per day, seven thousand dozens of oranges
per week and so on.

WHAT DETERMINES DEMAND?

i. Price of the commodity:
ii. Price of related commodities:
 complementary goods and
 competing goods or substitutes.
iii. Disposable Income of the consumer:
iv. Tastes and preferences of buyers
External effects on utility such as' demonstration effect',' bandwagon
effect’, Veblen effect and ‘snob effect’ do play important roles in determining the
demand for a product.
Difference between Demonstration/Bandwagon Effect and Snob Effect
Demonstration/Bandwagon Snob Effect
Effect
It is a psychological effect in It is understood as the desire to
which people do the same possess a unique commodity
what others are doing. They having a prestige value. It is quite
do not have their own belief opposite to the bandwagon or
and thinking. demonstration effect.
It leads to increase in demand It leads to decrease in demand
of a particular commodity. of a particular commodity.
Example: When some people Example: If Miss. X and Miss. Y
start investing money in are rich rivals of each other and
share market then many if in any party Miss. X wears an
people start following the Expensive dress and on seeing it
same without considering its Miss. Y who also having the same
advantages and Dress decided to reject the use
disadvantages. of the same dress further. Rather
Miss. Y will try to use even more
Expensive one.

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v. Consumers’ Expectations
Consumers’ expectations regarding future prices, income, supply conditions
etc. influence current demand. If the consumers expect increase in future
prices, increase in income and shortages in supply, more quantities will be
demanded.

Other factors:
a) Size of population:
b) Age Distribution of population:
c) The level of National Income and its Distribution:
d) Consumer-credit facility and interest rates:
e) Government policies and regulations:

THE DEMAND FUNCTION

As we know, a function is a symbolic statement of a relationship between the
dependent and the independent variables.
The demand function states in equation form, the relationship between the
demand for a product (the dependent variable) and its determinants (the
independent or explanatory variables).
Qx= f (PX, Y, Pr,)
Where
Qx is the quantity demanded of product X
PX is the price of the commodity
Y is the money income of the consumer, and
Pr is the price of related goods

THE LAW OF DEMAND

The law of demand states that other things being equal, when the price of a good rises ,
the quantity demanded of the good will fall. Thus, there is an inverse relationship
between price and quantity demanded,

Demand Schedule
A demand schedule is a table showing the quantities of a good that buyers would
choose to purchase at different prices, per unit of time, with all other variables
held constant.

Demand Schedule of an Individual Buyer

Price per cup of Quantity of ice-cream
ice-cream demanded (per week)
(in ₹) (Cups)
A 60 0
B 50 2
C 40 4
D 30 6
E 20 8
F 10 10
G 0 12

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The Demand Curve

A demand curve is a graphical presentation of the demand schedule. By
convention, the vertical axis of the graph measures the price per unit of the good.

Rationale of the Law of Demand

1. Price Effect of a fall in price:
a) Substitution effect:
The substitution effect describes the change in demand for a product when
its relative price changes. When the price of a commodity falls, the price
ratio between items change and it becomes relatively cheaper than other
commodities.
a. the goods are closer substitutes
b. there is lower cost of switching to the substitute good
c. there is lower inconvenience while switching to the substitute good

b) Income effect:
The increase in demand on account of an increase in real income is known
as 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 the case of inferior goods, the expansion in demand due to a price fall
will take place only if the substitution effect outweighs the income effect.
2. Utility maximising behaviour of Consumers:
3. Arrival of new consumers:
4. Different uses:

Exceptions to the Law of Demand

i. Conspicuous goods:
ii. Giffen goods:
iii. Conspicuous necessities:
iv. Future expectations about prices:
v. Incomplete information and irrational behaviour:
vi. Demand for necessaries:
vii. Speculative goods

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EXPANSION AND CONTRACTION OF DEMAND

The demand schedule, demand curve and the law of demand all show that when
the price of a commodity falls, its quantity demanded increases, other things
being equal. When, as a result of decrease in price, the quantity demanded
increases, in Economics, we say that there is an expansion of demand and when,
as a result of increase in price, the quantity demanded decreases, we say that
there is a contraction of demand.

Increase and Decrease in Demand

There are factors other than price (non-price factors) or conditions of demand
which might cause either an increase or decrease in the quantity of a particular
good or service that buyers are prepared to demand at a given price. What
happens if there is a change in consumers’ tastes and preferences, income, the
prices of the related goods or other factors on which demand depends

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 incomes, tastes or the price of
some other goods, have changed.
In short ‘change in demand’ represents shift of the demand curve to right or left
resulting from changes in factors such as income, tastes, prices of other goods
etc. and ‘change in quantity demanded’ represents movement upwards or
downwards on the same demand curve resulting from a change in the price of
the commodity.

ELASTICITY OF DEMAND
The point of view of a business firm, it is more important to know the extent of
the relationship or the degree of responsiveness of demand to changes in its
determinants.
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` Consider the following situations:

1. As a result of a fall in the price of headphones from ` 500 to ` 400, the
quantity demanded increases from 100headphones to 150 headphones.
2. As a result of fall in the price of wheat from ` 20 per kilogram to ` 18 per
kilogram, the quantity demanded increases from 500 kilograms to 520
Kilograms.
3. As a result of fall in the price of salt from ` 9 per kilogram to ` 7.50, the
quantity demanded increases from 1000 kilogram to 1005 kilograms.

Elasticity of demand is defined as the degree of responsiveness of the quantity

demanded of a good to changes in one of the variables on which demand
depends. More precisely, elasticity of demand is the percentage change in
quantity demanded divided by the percentage change in one of the variables on
which demand depends.

The most important measure of elasticity of demand is the price elasticity of

demand which measures the sensitivity of quantity demanded to ‘own price’ or
the price of the good itself.
 Knowledge of the nature and degree of price elasticity allows firms to
predict the impact of price changes on its sales.
 Price elasticity guides the firm’s profit-maximizing pricing decisions.

Price Elasticity =Ep= % change in quantity demanded /% change In Price

A negative sign on the elasticity of demand illustrates the law of demand:

less quantity is demanded as the price rises.

Measurement of Elasticity on a Linear Demand Curve – Geometric Method

The price elasticity of demand is the change in quantity associated with a change
in price (∆Q/∆P) times the ratio of price to quantity (P/Q) Therefore, the price
elasticity of demand depends not only on the slope of the demand curve but also
on the price and quantity.

RT / Rt = lower segment / upper segment

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Arc-Elasticity
Often we may be required to calculate price elasticity over some portion of the
demand curve rather than at a single point. In other words, the elasticity may be
calculated over a range of prices. When price and quantity changes are discrete
and large we have to measure elasticity over an arc of the demand curve.

The arc elasticity can be found out by using the formula: We drop the minus sign
and use the absolute value.

Interpretation of the Numerical Values of Elasticity of Demand

Elasticity Measures, Meaning and Nomenclature
Numerical measure Verbal Terminology
of elasticity description
Quantity demanded does Perfectly (or completely)
Zero not change as price changes inelastic
Greater than zero, Quantity demanded changes Inelastic
but less than one by a smaller percentage than
does price
One Quantity demanded changes Unit elasticity
By exactly the same
Percentage as does price
Greater than one, Quantity demanded changes Elastic
but less than by a larger percentage
Infinity than does price
Infinity Purchasers are prepared to Perfectly (or infinitely)
buy all they can obtain at elastic
Some price and none at all at
An even slightly higher price

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INCOME ELASTICITY OF DEMAND

Income elasticity of demand is the degree of responsiveness of the quantity
demanded of a good to changes in the income of consumers.
There is a useful relationship between income elasticity for a good and the
proportion of income spent on it. The relationship between the two is described
in the following three propositions:
1. If the proportion of income spent on a good remains the same as income
increases, then income elasticity for that good is equal to one.
2. If the proportion of income spent on a good increase as income increases,
then the income elasticity for that good is greater than one. The demand
for such goods increase faster than the rate of increase in income
3. If the proportion of income spent on a good decrease as income rises, then
income elasticity for the good is positive but less than one. The demand for
income-inelastic goods rise, but substantially slowly compared to the rate
of increase in income.

The following examples will make the above concepts clear:

a. The income of a household rises by 10%, the demand for wheat rises by 5%
b. The income of a household rises by 10%, the demand for T.V. rises by 20%.
c. The incomes of a household rises by 5%, the demand for bajra falls by 2%.
d. The income of a household rises by 7%, the demand for commodity X rises by
7%.
e. The income of a household rises by 5%, the demand for buttons does not
change at all.

CROSS - PRICE ELASTICITY OF DEMAND

Price of Related Goods and Demand
The demand for a particular commodity may change due to changes in the prices
of related goods. These related goods may be either complementary goods or
substitute 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 inter-related commodities, other things remaining the same.

a) Substitute Products and Demand

In the case of substitute commodities, the cross-demand curve slopes
upwards (i.e. positively), showing that more quantities of a commodity, will be
demanded whenever there is a rise in the price of a substitute commodity.
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b) Complementary Goods
In the case of complementary goods, as shown in the figure 11 below, a
÷
change in the price of a good will have an opposite reaction on the demand
for the other commodity which is closely related or complementary.

 If two goods are perfect substitutes for each other, the cross elasticity
between them is infinite.
 If two goods are close substitutes, the cross-price elasticity will be positive
and large.
 If two goods are not close substitutes, the cross-price elasticity will be
positive and small.
 If two goods are totally unrelated, the cross-price elasticity between them
is zero.

ADVERTISEMENT ELASTICITY
Advertisement elasticity of sales or promotional elasticity of demand is the
responsiveness of a good’s demand to changes in the firm’s spending on
advertising. The advertising elasticity of demand measures the percentage
change in demand that occurs given a one percent change in advertising
expenditure. Advertising elasticity measures the effectiveness of an
advertisement campaign in bringing about new sales.

Elasticity Interpretation
Ea = 0 Demand does not respond at all to increase in
advertisement expenditure

Ea>0 but < 1 Increase in demand is less than proportionate to

the increase in advertisement expenditure

Ea = 1 Demand increase in the same proportion in which

advertisement expenditure increase

Ea> 1 Demand increase at a higher rate than increase in

advertisement expenditure

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Chapter – 2
THEORY OF CONSUMER BEHAVIOUR
NATURE OF HUMAN WANTS
In economics, the term ‘want’ refers to a wish, desire or motive to own or/and
use goods and services that give satisfaction.
 All wants of human beings exhibit some characteristic features.
 Wants are unlimited in number. All wants cannot be satisfied.
 Wants differ in intensity. Some are urgent, others are less intensely felt
 “Utility” depends on intensity of wants.
 In general, Utility is satisfaction. But in economic sense, Utility is a
want satisfying power of a commodity.
 Each want is satiable
 Wants are competitive. They compete each other for satisfaction
because resources are scarce in relation to wants
 Wants are complementary. Some wants can be satisfied only by using
more than one good or group of goods
 A particular want may be satisfied in alternative ways
 Wants are subjective and relative. And hence, utility is also subjective or
relative concept.
 Wants vary with time, place, and person and hence utility.
 Some wants recur again whereas others do not occur again and again
 Wants may become habits and customs
 Wants are affected by income, taste, fashion, advertisements and social
norms and customs
 Wants arise from multiple causes such as physical and psychological
instincts, social obligations and individual’s economic and social status

CLASSIFICATION OF WANTS
Necessaries:
Necessaries are those which are essential for living. Necessaries are further
sub-divided into necessaries for life or existence, necessaries for efficiency and
conventional necessaries.
Comforts:
While necessaries make life possible comforts make life comfortable and
satisfying. Comforts are less urgent than necessaries.
Luxuries:
Luxuries are those wants which are superfluous and expensive. They are not
essential for living. Items such as expensive clothing, exclusive vintage cars,
classy furniture and goods used for vanity etc. fall under this category.

Total Utility and Marginal Utility

The two important concepts of utility are Total Utility (TU) and Marginal
Utility (MU) which are useful in theories of consumer behaviour.

TU refers to the sum total of utilities derived from the consumption of

all the units of a commodity consumed by a consumer at a given time.

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In other words, it is a sum of marginal utilities up to the units consumed by a

consumer. TU = ∑ MU

MU is the additional utility derived from the consumption of an additional unit

of the commodity. MU = TUn – TUn-1 Or MU = ∆TU /∆N

RELATIONSHIP BETWEEN TU & MU

Total and Marginal Utility Schedule
UNITS Total Utility (TU) Marginal Utility (MU)
0 0 -
1 10 10
2 18 8
3 23 5
4 25 2
5 25 0
6 23 -2

 Both TU and MU are interrelated. TU = ∑ MU & MU = TUn – TUn-1

 At first unit, TU = MU.
 Initially, when TU is increasing at decreasing rate, MU is decreasing but
remains positive.
 When TU is maximum and constant, MU = 0 (zero).
 When TU starts decreasing, MU becomes negative.

LAW OF DIMINISHING MARGINAL UTILITY

In simple words it says that as a consumer takes more units of a good, the extra
satisfaction that he derives from an extra unit of a good goes on falling.

Total and Marginal Utility Schedule

Quantity of tea Total Utility Marginal Utility

consumed (cups per day)
1 30 30
2 50 20
3 65 15
4 75 10
5 83 8
6 89 6
7 93 4
8 96 3
9 98 2
10 99 1
11 95 -4

The law of diminishing marginal utility is applicable only under certain

assumptions:
i. The different units consumed should be identical in all respects. The
habit, taste, treatment and income of the consumer also remain
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unchanged.
ii. The different units consumed should consist of standard units. If a
thirsty man is given water by successive spoonful, the utility of second
spoonful may conceivably be greater than the utility of the first.
iii. There should be no time gap or interval between the consumption of one
unit and another unit i.e. there should be continuous consumption.
iv. The law may not apply to articles like gold, cash where a greater quantity
may increase the lust for it.
v. The shape of the utility curve may be affected by the presence or absence
of articles which are substitutes or complements.

CONSUMER SURPLUS
Marshall defined the concept of consumer 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 consumers surplus.”
Thus, consumer surplus = what a consumer is ready to pay - what he actually
pays.

Measurement of Consumer Surplus

No. of units Marginal Utility Price (₹) Consumer
(worth ₹) 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 –

A fall in price from P to P1 increases consumer surplus from APE to A P1F.The

increase in consumer surplus has two components.
a) The increase in consumer surplus of existing buyers who were earlier paying
price P (the rectangle marked b).
b) The consumer surplus now available to the new buyers who started buying
the commodity due to lower prices (the triangle c)

INDIFFERENCE CURVE ANALYSIS

This approach uses a different tool namely indifference curve to analyse
consumer behaviour and is based on consumer preferences. The approach is
based on the belief that that human satisfaction, being a psychological
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phenomenon, cannot be measured quantitatively in monetary terms as was
attempted in Marshall’s utility analysis. Therefore, it is scientifically more
sound to order preferences than to measure them in terms of money.

Indifference Curves
The ordinal analysis of demand (here we will discuss the one given by Hicks and Allen)
is based on indifference curve which represent the consumer’s preferences graphically.
An indifference curve is a curve which represents all those combinations of two goods
which give same satisfaction to the consumer.
It represents the set of all bundles of goods that a consumer views as being equally
desirable. 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. An Indifference curve is also called iso-utility curve or equal utility curve.
Indifference Schedule
Combination Food Clothing MRS
A 1 12 -
B 2 6 6
C 3 4 2
D 4 3 1

An indifference curve IC is drawn by plotting the various combinations given in

the indifference schedule.

Indifference Curve Map

The entire utility function of an individual can be represented by an indifference curve
map which is a collection of indifference curves in which each curve corresponds to a
different level of satisfaction.
Combinations of goods lying on indifference curves which are farther from the origin
are preferred to those on indifference curves which are closer to the origin. Moving
upward and to the right from one indifference curve to the next represents an increase
in utility, and moving down and to the left represents a decrease.

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Properties of Indifference Curves

i. Indifference curves slope downward to the right:

ii. Indifference curves are always convex to the origin:

 When two goods are perfect substitutes of each other, the consumer is
completely indifferent as to which to consume and is willing to exchange
one unit of X for one unit of Y. His indifference curves for these two goods
are therefore straight, parallel lines with a constant slope along the
curve, or the indifference curve has a constant MRS.

 Goods are perfect complements when a consumer is interested in

consuming these only in fixed proportions. When two goods are perfect
complementary goods (e.g. left shoe and right shoe),

iii. Indifference curves can never

intersect each other:

iv. A higher indifference curve represents a higher level of satisfaction than the
lower indifference curve:

v. Indifference curve will not touch

either axes:

The Budget Line

From the ordinal utility analysis discus
Consumers maximize their well-being subject to constraints. The most
important constraint all of us face in deciding what to consume is the budget
constraint. In other words, consumers almost always have limited income,
which constrains how much they can consume. A consumer’s choices are
limited by the budget available to him. As we know, his total expenditure for
goods and services can fall short of the budget constraint, but may not exceed
it.
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A change in the prices of one or both products with the nominal income of the
buyer (budget) remaining the same.
A change in the level of nominal income of the consumer with the relative prices
of the two goods remaining the same.
A change in both income and relative prices

Consumer Equilibrium
The consumer has a given indifference map which shows his scale of
preferences for various combinations of two goods X and Y.
He has a fixed money income which he has to spend wholly on goods X and Y.
Prices of goods X and Y are given and are fixed.
All goods are homogeneous and divisible, and
The consumer acts ‘rationally’ and maximizes his satisfaction.

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Prof. Vinayak Jadhav 2.2.7

CA Foundation Course Elite Gurukul
Chapter -3: SUPPLY
INTRODUCTION
Three important points apply to supply:
i. Supply refers to what a firm offer for sale in the market, not necessarily
to what hey succeed in selling. What is offered may not get sold.
ii. Supply requires both willingness and ability to supply. Production cost is
often the primary influence on ability.
iii. Supply is a flow. Supply is identified for a specified time period. The
quantity supplied is ‘so much’ per unit of time, per day, per week, or per
year.

DETERMINANTS OF SUPPLY
i. Price of the good:
ii. Prices of related goods:
iii. Prices of factors of production:
iv. State of technology:
v. Government Policy:
vi. Nature of competition and size of industry:
vii. Expectations:
viii. Number of sellers:

THE LAW OF SUPPLY

Supply refers to the relationship of quantity supplied of a good with one or
more related variables which have an influence on the supply of the good.
The law of supply can be stated as: Other things remaining constant, 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.

Supply Schedule of Good ‘X’

Price (₹) (per kg) Quantity supplied (kg)
1 5
2 35
3 45
4 55
5 65

a) the highest quantity willingly supplied by the suppliers at each price and
b) the minimum price which will induce suppliers to offer the various
quantities for sale

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MOVEMENTS ON THE SUPPLY CURVE – INCREASE OR DECREASE IN THE
QUANTITY SUPPLIED
When the supply of a good increase as a result of an increase in its price, we
say that there is an increase in the quantity supplied and there is an upward
movement on the supply curve. A rise in market price causes an expansion of
supply; there is a upward movement on the supply curve and producers offer
more for sale. When market price falls, there is contraction of supply as
producers have less incentive to offer products for sale in the market.

While a change in quantity supplied is a movement along a given supply curve,

a change in supply is a shift of the supply curve. When the supply curve bodily
shifts towards the right 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 in supply. When the supply curve shifts to the right, more
is offered for sale at each price.

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.
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑆𝑢𝑝𝑝𝑙𝑖𝑒𝑑
𝐸𝑠 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒

Types of Supply Elasticity

i. Perfectly inelastic supply:
ii. Relatively less-elastic supply:
iii. Relatively greater-elastic supply :
iv. Unit-elastic:
v. Perfectly elastic supply:

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Measurement of supply-elasticity
Arc-Elasticity: Arc-elasticity i.e. elasticity of supply between two prices can be found
out with the help of the following formula:

EQUILIBRIUM PRICE
Supply and Demand Schedule

Price (₹) Quantity Demanded Quantity Supplied Impact on price

5 6 31 Downward
4 12 25 Downward
3 19 19 Equilibrium
2 25 12 Upward
1 31 6 Upward

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Market Equilibrium and Social Efficiency

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CA Foundation Course Elite Gurukul
CHAPTER – 3 THEORY OF PRODUCTION AND COST
Unit 1: PRODUCTION
MEANING OF PRODUCTION:
Production is a very important economic activity. As we are aware, the
survival of any firm in a competitive market depends upon its ability to
produce goods and services at a competitive cost.The amount of goods and
services an economy is able to produce determines the richness or poverty of
that economy. In fact, the standard of living of people depends on the volume
and variety of goods and services produced in a country.

“Production is the organized activity of transforming resources into finished

products in the form of goods and services; and the objective of production is
to satisfy the demand of such transformed resources”.

FACTORS OF PRODUCTION:
Factors of production refer to inputs. An input is a good or service which
a firm buys for use in its production process. Production process requires a
wide variety of inputs, depending on the nature of output. A good has to pass
through many stages and many hands until it reaches the consumers’ hands.
in a finished form Land, labour, capital and entrepreneurial ability are the
four factors or resources which make it possible to produce goods and
services.

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 land in common parlance, natural resources, fertility of soil,
water, air, light, heat natural vegetation etc.
i. Land is a free gift of nature
ii. Supply of land is fixed
iii. Land is permanent and has indestructible powers
iv. Land is a passive factor
v. Land is immobile
vi. Land has multiple uses
vii. Land is heterogeneous

Labour:
The term ‘labour’, means any mental or physical exertion directed to produce
goods or services. All human efforts of body or of mind undergone partly or
wholly with a view to secure an income apart from the pleasure derived
directly from the work is termed as labour.

Characteristics of labour:
 Human Effort
 Labour is perishable
 Labour is an active factor
 Labour is inseparable from the labourer
 Labour power differs from labourer to labourer

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 All labour may not be productive
 Labour has poor bargaining power
 Labour is mobile
 There is no rapid adjustment of supply of labour to the demand for it
 Choice between hours of labour and hours of leisure

Capital:
We may define capital as that part of wealth of an individual or community
which is used for further production of wealth.
Capital has been rightly defined as ‘produced means of production’ or ‘man-
made instruments of production’. In other words, capital refers to all man made
goods that are used for further production of wealth.It has been produced by
man by working with nature. Machine tools and instruments, factories, dams,
canals, transport equipment etc., are some of the examples of capital.

Types of Capital:
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.

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, fuel,
raw materials, etc.

Real capital refers to physical goods such as building, plant, machines, etc.

Human capital refers to human skill and ability. This is called human capital
because a good deal of investment goes into creation of these abilities in
humans.

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, copyrights, goodwill, patent rights, etc.

Individual capital is personal property owned by an individual or a group of

individuals.

Social Capital is what belongs to the society as a whole in the form of roads,
bridges, etc.

Capital Formation:
Capital formation means a sustained increase in the stock of real capital in
a country.

Stages of capital formation:

1. Savings:
The basic factor on which formation of capital depends is the ability to

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save. The ability to save depends upon the income of an individual. Higher
incomes are generally followed by higher savings.It is not only the ability to
save, but the willingness to save also counts a great deal. Willingness to save
depends upon the individual’s concern about his future as well as upon the
social set-up in which he lives.

2. Mobilisation of savings:
It is not enough that people save money; the saved money should enter
into circulation and facilitate the process of capital formation.
There should be a wide spread network of banking and other financial
institutions to collect public savings and to take them to prospective investors.

3. Investment:
The process of capital formation gets completed only when the real
savings get converted into real capital assets. An economy should have an
entrepreneurial class which is prepared to bear the risk of business and
invest savings in productive avenues so as to create new capital assets.

Entrepreneur:
Having explained the three factors namely land, labour and capital, we now
turn to the description of the fourth factor of production, 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: In general, an entrepreneur performs the

following functions:
i. Initiating business enterprise and resource co-ordination:
An entrepreneur senses business opportunity, conceives project
ideas, decides on scale of operation, products and processes and builds up,
owns and manages his own enterprise.

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
and planned.

iii. Innovations:
According to Schumpeter, the task of the entrepreneur is to
continuously introduce new innovations. These innovations may bring in
greater efficiency and competitiveness in business and bring in profits to the
innovator. A successful innovation will be imitated by others in due course of
time. Therefore, an innovation may yield profits for the entrepreneur for a short
time but when it is widely adopted by others, the profits tend to disappear.

Enterprise’s objectives and constraints:

The standard assumption about an enterprise is that its business activity
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is carried out with the sole objective of earning profits. However, in the real
world, enterprises do not make decisions based exclusively on profit
maximisation objective alone.

1. Organic objectives:
The basic minimum objective of all kinds of enterprises is to survive or to
stay alive. An enterprise can survive only if it is able to produce and distribute
products or services at a price which enables it to recover its costs.

2. Economic objectives:
The profit maximising behaviour of the firm has been the most basic
assumption made by economists over the last more than two hundred years
and is still at the theory.

The definition of profits in Economics is different from the accountants’

definition of profits. Profit, in the accounting sense, is the difference between
total revenue and total costs of the firm. Economic profit is the difference
between total revenue and total costs, but total costs here costs include both
explicit and implicit costs.

Normal profit (zero economic profit) is a component of costs and therefore what
a business owner considers as the minimum necessary to continue in the
business. Supernormal profit, also called economic profit or abnormal profit is
over and above normal profits. It is earned when total revenue is greater than
the total costs. Total costs in this case include a reward to all the factors,
including normal profit.

3. Social objectives:
Since an enterprise lives in a society, it cannot grow unless it meets the
needs of the society. Some of the important social objectives of business are:
 To maintain a continuous and sufficient supply of unadulterated goods
and articles of standard quality.
 To avoid profiteering and anti-social practices.
 To create opportunities for gainful employment for the people in the
society.
 To ensure that the enterprise’s output does not cause any type of
pollution - air, water or noise.

4. Human objectives:
Human beings are the most precious resources of an organisation. If they
are ignored, it will be difficult for an enterprise to achieve any of its other
objectives.
 To provide fair deal to the employees at different levels
 To develop new skills and abilities and provide a work climate in which
they will grow as mature and productive individuals.
 To provide the employees an opportunity to participate in decision-
making in matters affecting them.

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 To make the job contents interesting and challenging.

5. National objectives:
An enterprise should endeavour for fulfilment of national needs and
aspirations and work towards implementation of national plans and policies.
Some of the national are: objectives
 To remove inequality of opportunities and provide fair opportunity to all to
work and to progress.
 To produce according to national priorities.
 To help the country become self-reliant and avoid dependence on other
nations.
 To train young men as apprentices and thus contribute in skill formation
for economic growth and development.

Enterprise’s Problems:
An enterprise faces a number of problems from its inception, through its life
time and till its closure

Problems relating to objectives:

As mentioned earlier, an enterprise functions in the economic, social,
political and cultural environment. Therefore, it has to set its objectives in
relation to its environment. The problem is that these objectives are
multifarious and very often conflict with one another.

Problems relating to location and size of the plant:

An enterprise has to decide about the location of its plant. It has to
decide whether the plant should be located near the source of raw material or
near the market. It has to consider costs such as cost of labour, facilities and
cost of transportation.

Problems relating to selecting and organising physical facilities:

A firm has to make decision on the nature of production process to be
employed and the type of equipments to be installed. The choice of the process
and equipments will depend upon the design chosen and the required volume
of production.

Problems relating to Finance:

An enterprise has to undertake not only physical planning but also
expert financial planning. Financial planning involves (i) determination of the
amount of funds for the enterprise with reference to the physical plans already
prepared (ii) assessment of demand and cost of its products (iii) estimation of
profits on investment and comparison with the profits of comparable existing
concerns to find out whether the proposed investment will be profitable enough
and (iv) determining capital structure and the appropriate time for financing
the enterprise etc.

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Problems relating to organisation structure:

An enterprise also faces problems relating to the organisational
structure. It has to divide the total work of the enterprise into major specialised
functions and then constitute proper departments for each of its specialized
functions

Problems relating to marketing:

Proper marketing of its products and services is essential for the
survival and growth of an enterprise. For this, the enterprise has to discover its
target market by identifying its actual and potential customers, and determine
tactical marketing tools it can use to produce desired responses from its target
market.
 Product: variety, quality, design, features, brand name, packaging,
associated services, utility etc.
 Promotion: Methods of communicating with consumers through personal
selling, social contacts, advertising, publicity etc.
 Price: Policies regarding pricing, discounts, allowance, credit terms,
concessions, etc.
 Place: Policy regarding coverage, outlets for sales, channels of distribution,
location and layout of stores, inventory, logistics etc

Problems relating to legal formalities: A number of legal formalities have to

be carried out during the time of launching of the enterprise as well as during
its life time and its closure. These formalities relate to assessing and paying
different types of taxes (corporate tax, excise duty, sales tax, custom duty, etc.),
maintenance of records, submission of various types of information to the
relevant authorities from to time.

Problems relating to industrial relations: With the emergence of the present

day factory system of production, the management has to devise special
measures to win the cooperation of a large number of workers employed in
industry. Misunderstanding and conflict of interests have assumed enormous
dimensions that these cannot be easily and promptly dealt with. Industrial
relations at present are much more involved and complicated.

PRODUCTION FUNCTION
The production function is a statement of the relationship between a firm’s
scarce resources (i.e. its inputs) and the output that results from the use of
these resources. More specifically, it states technological relationship between
inputs and output. The production function can be algebraically expressed in
the form of an equation in which the output is the dependent variable and
inputs are the independent variables. The equation can be expressed as:
Q = f (a, b, c, d …….n)

Assumptions of Production Function: There are three main assumptions

underlying any production function.
First we assume that the relationship between inputs and outputs exists for a

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specific period of time. In other words, Q is not a measure of accumulated
output over time.

Second, it is assumed that there is a given “state-of-the-art” in the production

technology. Any innovation would cause change in the relationship between
the given inputs and their output.

Third assumption is that whatever input combinations are included in a

particular function, the output resulting from their utilization is at the
maximum level.

The relationship between the maximum amount of output that can be

produced and the input required to make that output. It is defined for a given
state of technology.

It can also be defined as the minimum quantities of various inputs that are
required to yield a given quantity of output.

The output takes the form of volume of goods or services and the inputs are the
different factors of production i.e., land, labour, capital and enterprise.

Short-Run Vs Long-Run Production Function

The production function of a firm can be studied in the context of short period
or long period.

The distinction between short-run and long-run is not related to any particular
measurement of time (e.g. days, months, or years). In fact, it refers to the
extent to which a firm can vary the amounts of the inputs in the production
process. A period will be considered short-run period if the amount of at least
one of the inputs used remains unchanged during that period.

Thus, short-run production function shows the maximum amount of a good or

service that can be produced by a set of inputs, assuming that the amount of at
least one of the inputs used remains fixed (or unchanged). a firm cannot install
a new capital equipment to increase production. It implies that capital is a fixed
factor in the short run.

The long run is a period of time (or planning horizon) in which all
factors of production are variable. It is a time period when the firm will be able
to install new machines and capital equipments apart from increasing the
variable factors of production. A long-run production function shows the
maximum quantity of a good or service that can be produced by a set of inputs,
assuming that the firm is free to vary the amount of all the
inputs being used.

Cobb-Douglas Production Function

The Law of Variable Proportions or The Law of Diminishing Returns
In the short run, the input output relations are studied with one variable input
(labour) with all other inputs held constant. The laws of production under these
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conditions are known under various names as the law of variable proportions
(as the behaviour of output is studied by changing the proportion in which
inputs are combined) the law of returns to a variable input (as any change in
output is taken as resulting from the additional variable input) or the law of
diminishing returns (as returns eventually diminish).

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.

Table 1: Product Schedule

Quantity of Total Average Marginal

labour Product (TP) Product (AP) Product (MP)
(1) (2) (3) (4)
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
10 750 75.0 0
11 740 67.3 –10

Average Product (AP): Average product is the total product per unit of the
variable factor.
AP = Total Product / No. of units of Variable Factors

Marginal Product (MP): Marginal product is the change in total product per
unit change in the quantity of variable factor.
MP n = TP n – TP n-1

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 the
variable factor and marginal product is the change in total product resulting
from a unit increase in the quantity of variable factor.
i. when average product rises as a result of an increase in the quantity of
variable input, marginal product is more than the average product.
ii. when average product is maximum, marginal product is equal to average
product. In other words, the marginal product curve cuts the average
product curve at its maximum.
iii. when average product falls, marginal product is less than the average
product.

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Stage 1: The Stage of Increasing Returns: In this stage, the 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 the point of
inflexion and average product goes on rising.

Explanation of law of increasing returns: The law of increasing returns

operates because in the beginning, the quantity of fixed factors is abundant
relative to the quantity of the variable factor. As more units of the variable
factor are added to the constant quantity of the fixed factors, 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.

Stage 2: Stage of Diminishing Returns: In stage 2, the total product continues

to increase at a diminishing rate until it reaches its maximum at 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.

Stage 3: Stage 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.

Returns to Scale
When all factors of production in a particular production function are increased
together. In other words, 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.

Changes in output as a result of the variation in factor proportions, as seen

before, form the subject matter of the law of variable proportions.
Returns to scale may be constant, increasing or decreasing. If we increase all
factors
i.e., scale in a given proportion and output increases in the same proportion,
returns to scale are said to be constant.
It should be remembered that increasing returns to scale is not the same as
increasing marginal returns. Increasing returns to scale applies to ‘long run’ in
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which all inputs can be changed. Increasing marginal returns refers to the
short run in which at least one input is fixed.

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.
Constant returns to scale, otherwise called as “Linear Homogeneous Production
Function”, may be expressed as follows:
If all the inputs are increased by a certain amount (say k) output increases in
the same proportion (k).

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.

Decreasing Returns to Scale: When output increases in a smaller proportion

relative to an increase in all inputs, decreasing returns to scale are said to
prevail. When a firm goes on expanding by increasing all inputs, decreasing
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 earlier.

If a + b > 1 Increasing returns to scale result i.e. increase in output is more

than the proportionate increase in the use of factors (labour and capital).
If a + b = 1 Constant returns to scale result i.e. the output increases in the
same proportion in which factors are increased.
If a + b < 1 decreasing returns to scale result i.e. the output increases less than
proportionate increase in the labour and capital.

PRODUCTION OPTIMISATION
Isoquants: Isoquants are similar to indifference curves in the theory of
consumer behaviour. An isoquant represents all those combinations of inputs
which are capable of producing the same level of output. Since an isoquant
curve represents all those combinations of inputs which yield an equal quantity
of output, the producer is indifferent as to which combination he chooses.
Therefore, Isoquants are also called equal-product curves, production
indifference curves or iso-product curves.

Table 2 : Various combinations of X and Y to produce a given level of output

Factor combination Factor X Factor Y MRTS
A 1 12
B 2 08 4
C 3 05 3
D 4 03 2
E 5 02 1

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Isoquants have properties similar to indifference curves. Isoquants are

negatively sloped, convex to the origin due to diminishing marginal rate of
technical substitution (MRTS) and are non-intersecting. However, there is one
important difference between the two: whereas in an indifference curve it is not
possible to quantify the level of satisfaction acquired by the consumer, the level
of production acquired by the producer is easily quantified.
Isocost or Equal-cost Lines: Isocost line, also known as budget line or the
budget constraint line, shows the various alternative combinations of two
factors which the firm can buy with given outlay

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Theory Of Cost

COST CONCEPTS
Types of Costs
 Accounting Costs and Economic costs
 Outlay costs and Opportunity costs
 Direct or Traceable costs and Indirect or Non-Traceable costs
 Incremental costs and Sunk costs
 Historical costs and Replacement costs
 Private costs and Social costs
 Fixed and Variable costs

Accounting Costs and Economic costs

Accounting Costs Economic costs
Explicit Cost Implicit Cost
Cash Payment made by entrepreneur Cost of self owned or self
supplied cost Factors
All Charges and payments made by Economic cost is sum of Normal
Entrepreneur return of Capital, wages and
salary not paid and monetary
rewards for all factors
Expenses already incurred or it is also EC = Actual Cost + Cost of Self
known as Actual money Expenditure owned Factors
or Actual Cost

Economic Cost = Explicit Cost + Implicit Cost (Including Normal Return)

Economic Cost is more the Accounting Cost.
TR = IC + EC → Zero Economic Profit
TR = IC + EC → Supernormal or Abnormal Profit

Outlay costs and Opportunity costs

Opportunity Costs Outlay costs

IT is the next best opportunity forgo. Actual Expenditure of the fund
It is the cost of missed opp Involved in Financial Expenditure
Amount/Subjective value which is Recorded in Books of Accounts.
forgone
Related to the sacrificed alternative
Generally, not recorded in the books
of Accounts

Direct or Traceable costs and Indirect or Non-Traceable costs

Direct or Traceable costs Indirect or Non-Traceable costs
Direct costs are those which have Indirect costs are those which
direct relationship with a component Are not easily and definitely
operation like manufacturing a Identifiable in relation to a
product, organizing a process or an plant, product, process or
activity department.

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Eg: Specific Cost, Machinery Fuel Eg Common Cost, Electicity

Incremental costs and Sunk costs

Sunk costs Incremental costs
Sunk costs refer to those costs which Incremental cost refers to the
are already incurred once and for all additional cost incurred by a
and cannot be recovered. firm as result of a business
decision.

Historical costs and Replacement costs:

Historical costs Replacement costs
Historical cost refers to the cost Replacement cost is the money
incurred in the past on the expenditure that has to be
acquisition of a productive asset such incurred for replacing an old
as machinery, building etc. asset.

Private costs and Social costs:

Private costs Social Cost
Private costs are costs actually It includes the cost of resources
incurred or provided for by firms and for which the firm is not
are either explicit or implicit. required to pay price such as
atmosphere, rivers, roadways
etc.

Fixed and Variable costs

Fixed Cost Variable Cost
Fixed or constant costs are not a Variable costs are costs that are
function of output; they do not vary a function of output in the
with output upto a certain level of production period.
activity.

e.g., rent, property taxes, interest on For example, wages of casual

loans and depreciation when taken labourers and cost of raw
as a function of time and not of materials and cost of all other
output. inputs that vary with output are
variable costs.

Fixed costs cannot be avoided. These Variable costs vary directly and
costs are fixed so long as operations sometimes proportionately with
are going on. They can be avoided output.
Only when the operations are
completely closed down.

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COST FUNCTION
 Cost function refers to the mathematical relation between cost of a
product and the various determinants of costs.

Variable Cost
The cost which vary with level of output. Associated with the variable factors of
production

Fixed Cost
the cost which remain same on every level of output. Associate with Fixed Factor of
production.

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.

A Stair-step Variable Cost

There are some costs which may increase in a stair-step fashion, i.e., they
remain fixed over certain range of output; but suddenly jump to a new higher
level when output goes beyond a given limit.

Total Cost
Sum of Expenses incurred to produce particular level of output
Total Variable Cost
Sum of Variable Expenses incurred to produce a particular level of output.
Total Fixed Cost
Sum of Fixed Expenses incurred to produce a particular level of output.

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Nature of Total Variable Cost

Initially it increases with decreasing rate there after it increases with
increasing rate
Unit per Variable Labour TP
Factors
0 0 -
1 100 10
2 200 25
3 300 50
4 400 55

TP increase with increase Rate Proper utilization of Fixed Factors, specialization

TP increase with Decreasing Rate Over Utilization of Fixed Factors

Per Unit Variable Cost Avg Variable Cost

100/10 = Rs 10 per unit
200/25 = Rs 8 per unit
300/50 = Rs 6 per unit
400/55 = Rs 7.3 per Unit

Decrease (AVC)  Total Variable cost increase with decrease Rate

Increase (AVC)  Total Variable cost increase with Increase Rate

Total Cost = Total Variable Cost + Total Fixed Cost

TC curve is Greater than TVC Curve

TC Curve Lies above because TC is vertical sum of TVC & TFC
TC Curve is Parallel to TVC Curve because there difference is TFC which is
constant throughout.
At zero level of out put TVC becomes Zero, but TFC is found even at zero level of
output.

Average Cost
Per unit cost of producing output

Average Variable Cost

Per unit Variable cost of producing output.

Unit per Variable Labour TP Per Unit Variable Cost

Factors Avg Variable Cost
0 0 -
1 100 10 100/10 = Rs 10 per unit
2 200 25 200/25 = Rs 8 per unit
3 300 50 300/50 = Rs 6 per unit
4 400 55 400/55 = Rs 7.3 per Unit

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Points to Remember.
Initially due to proper utilization of Fixed Factors & Specialization, TP increases
with increase rate per unit variable cost. There AVC Starts Falling.

After a point, due to overutilization of fixed factors. TP increase with decreasing

rate per unit variable cost. There for AVC starts increasing.

Average Fixed Cost

Per Unit Fixed Cost of producing output.
Output TFC AFC
1 100 100
2 100 50
3 100 33.33
4 100 25
5 100 20

Points to Remember.
1. AFC curve falls throughout the case.
2. AFC curve will not touch the x axis which indicates the output because
Fixed Cost cannot be Zero.
3. AFC Curve is also known as Rectangular hyperbola.
4. Area of 2 Rectangle form by 2 point on curve Will be Equal to Each other.

AC Curve
Points to Remember.
1. Diagrammatically AC curve is Vertical Sum of AVC & AFC Curve.
2. Difference between AC & AFC Curve Continuously Falls because the
difference of AFC which Continuously fall with increase in output.
3. AC & AVC Curve will Never touch Each other because their difference is
AFC which never Become Zero.
4. Ac Curve Lies above the AVC Curve Because it Includes AFC as Well.

AC Curve & AP Curve.

Points to Remember
1. When Average Production Rises, Average Cost Falls When Avg. production
becomes maximum Avg. Cost becomes minimum.
2. When Avg. Production falls, Avg. cost starts rising.

Marginal Cost
Change in total Cost due to production of an Additional unit of Output.
Output TVC TFC TC MC
0 0 10 10 -
1 10 10 20 20 -10 = 10 10
2 18 10 28 28 – 20 = 8 18
3 25 10 35 35 – 28 = 7 25
4 35 10 45 45 – 35 = 10 35

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Relationship between Avg. Cost & Marginal Cost
Points to Remember.
1. When Both MC & AC Fall, MC Falls with faster rate.
2. When Both MC and Ac Rises, MC Rises with faster rate.
3. MC Cuts AC at its Minimum point.
4. There may be a situation when MC rising but AC is Falling.

LONG RUN AVERAGE COST CURVE

1. Long run is a period of time during which the firm can vary all of its
inputs.
2. It is the least possible cost of producing any given level of output when all
individual factors are variable.
3. It depicts the functional relationship between output and the long run cost
of production. Any firm in actually operates in the short run and plans
for the long run.
4. The long run being a planning horizon, the firm plans ahead to build the
most appropriate scale of plant to produce the future level of output that
a big plant if it wants to increase its output and a small want to reduce
its output.
5. The 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.
6. The long-run average cost curve is also called “Envelope curve”,
7. Short run average cost curves (SACs) are also called ‘plant curves’.

Short Run Average Cost Curves

In the long run, the firm will examine with which size of plant or on which short
run average cost curve it should operate to produce a given level of output, so
that the total cost is minimum.

Long Run Average Cost Curves

1. It is to be noted that LAC curve is not tangent to the minimum points of
the SAC curves.
2. “OQ” is the optimum output.
3. On the other hand, for outputs larger than OQ the firm will construct a
plant and operate it beyond its optimum capacity.

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ECONOMIES AND DISECONOMIES OF SCALE

1. Economies arising out of large-scale production can be grouped into two
categories; viz., internal economies and external economies.
2. 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.
3. These economies arise within the firm and are available exclusively to the
expanding firm.
4. External economies are the benefits accruing to each member firm of the
industry as a result of expansion of the industry.

INTERNAL ECONOMIES & DISECONOMIES

1. Technical economies and diseconomies 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.
2. For producing higher levels of output, there is generally available a more
efficient machinery which when employed to produce a large output yield
a lower cost per unit of output.
3. Beyond a certain point, a firm experiences net diseconomy of scale
4. 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,

Managerial economies and diseconomies:

1. Managerial economies refer to reduction in managerial costs. When output
increases, specialisation and division of labour can be applied to
management.
2. It becomes possible to divide its management into specialised departments
under specialised personnel, such as production manager, sales manager,
finance manager etc.
3. However, as the scale of production increases beyond a certain limit,
managerial diseconomies set in.
4. 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.
5. Management finds it difficult to exercise control and to bring in
coordination among its various departments.

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Commercial economies and diseconomies:
1. 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.
2. 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.

Financial economies and diseconomies:

1. A large firm has advantages over small firms in matters related to
procurement of finance for its business activities.
2. 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.
3. 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.

Risk bearing economies and diseconomies:

1. 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.
2. Risk may increase if diversification, instead of giving a cover to economic
disturbances, increases these.

External Economies and Diseconomies:

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

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 equipment.

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.

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.

Growth of ancillary industries:

Expansion of industry encourages the growth of a number of ancillary industries
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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.

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.

Economies of Information:
1. 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.
2. External diseconomies are disadvantages that originate outside the firm,
especially in thein put markets.
3. An example of external diseconomies is rise in various factor prices.
4. When an industry expands the requirement of various factors of
such as raw materials, capital goods, skilled labour etc increases.
5. Especially when they are short in supply
6. Moreover, too many firms in an industry at one place may also result in
higher transportation cost, marketing cost and high pollution control cost.
7. The government may also, through its location policy, prohibit or restrict
the expansion of an industry at a particular place.

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Prof. Vinayak Jadhav 3.2.10

CA Foundation Course Elite Gurukul
CHAPTER 4 -PRICE DETERMINATION IN DIFFERENT MARKETS
Unit 1
Classification of Market
Markets are generally classified into product markets and factor markets.
Product markets are markets for goods and services in which households buy
the goods and services they want from firms.
While product markets allocate goods to consumers, factor markets allo-cate
productive resources to producers and help ensure that those resources are
used efficiently.

Generally, the classification of markets is made on the basis of

On the basis of geographical area
Local Markets: When buyers and sellers are limited to a local area or region,
the market is called a local market. Generally, highly perishable goods and
bulky articles, the transport of which over a long distance is uneconomical’
command a local market.

Regional Markets: Regional markets cover a wider area such as a few

adjacent cities, parts of states, or cluster of states. The size of the market is
generally large and the nature of buyers may vary in their demand
characteristics. For eg. Mekhela Chador (Traditional Assamese Saree) is
primarily worn by women in Assam and adjoining areas.

National Markets: When the demand for a commodity or service is limited to

the national boundaries of a country, we say that the product has a national
market. The trade policy of the government may restrict the trading of a
commodity to within the country. For example Hindi books may have national
markets in India;

International markets: A commodity is said to have international market

when it is exchanged internationally. Usually, high value and small bulk
commodities are demanded and traded internationally. For example Gold and
Silver

On the basis of Time

Very short period market: Market period or very short period refers to a
period of time in which supply is fixed and cannot be increased or decreased.
Commodities like vegetables, flower, fish, eggs, fruits, milk, etc., which are
perishable and the supply of which cannot be changed in the very short period
come under this category.

Short-period Market: Short period is a period which is slightly longer than

the very short period. In this period, the supply of output may be increased by
increasing the employment of variable factors with the given fixed factors and
state of technology.

Long-period Market: In the long period, all factors become variable and the
supply of commodities may be changed by altering the scale of production. As
such, supply may be fully adjusted to changes in demand conditions.
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Very long-period or secular period is one when secular movements are

recorded in certain factors over a period of time. The period is very long. The
factors include the size of the population, capital supply, supply of raw
materials etc.

On the basis of Nature of Transactions

a) Spot or cash Market: Spot transactions or spot markets refer to those
markets where goods are exchanged for money payable either immediately
or within a short span of time.
b) Forward or Future Market: In this market, transactions involve contracts
with a promise to pay and deliver goods at some future date.

On the basis of Regulation

a) Regulated Market: In this market, transactions are statutorily regulated
so as to put an end to unfair practices.
b) Unregulated Market: It is also called a free market as there are no
stipulations on the transactions.

On the basis of volume of Business

a) Wholesale Market: The wholesale market is the market where the
commodities are bought and sold in bulk or large quantities.
b) Retail Market: When the commodities are sold in small quantities, it is
called retail market.

On the basis of Competition

Based on the type of competition markets are classified into a) perfectly
competitive market and b) imperfectly competitive market

TYPES OF MARKET STRUCTURES

Perfect Competition: Perfect competition is characterised by many sellers
selling identical products to many buyers.

Monopolistic Competition: It differs in only one respect, namely, there are

many sellers offering differentiated products to many buyers. For example,
shampoo manufacturers.

Monopoly: It is a situation where there is a single seller producing for many

buyers. Its product is necessarily extremely differentiated since there are no
competing sellers producing products which are close substitutes. For example:
Indian Railways.

Oligopoly: There are a few sellers selling competing products to many buyers.
For example: Telecom Industry.

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Assumption Market Types

Perfect Monopolistic Oligopoly Monopoly
Competition Competition
Number of Very large Large Small One
sellers numbers

Product None Slight None to Extreme

differentiation substantial

Price elasticity Infinite Large Small Small

of demand of a
firm
Degree of None Some Some Very
control over considerable
price

REVENUE AND MARGINAL REVENUE

Total Revenue
Total revenue may be expressed as TR = P x Q.
Where, TR is total revenue
P is price of a commodity sold. Q is quantity of a commodity sold.

Average Revenue: Average revenue is the revenue earned per unit of output.
It is nothing but price of one unit of output because price is always per unit of
a commodity.
AR = 𝑇𝑅
𝑄
Where AR is average revenue
TR is the total revenue
Q is quantity of a commodity sold

Or AR = 𝑃 × 𝑄
𝑄

Or AR = P

Marginal Revenue: Marginal revenue (MR) is the change in total revenue

resulting from the sale of an additional unit of the commodity.

MR = ∆𝑇𝑅
∆𝑄
Where MR is marginal revenue
TR is total revenue
Q is quantity of a commodity sold
stands for a small change

Table 2: Total Revenue, Average Revenue and Marginal Revenue

Prof. Vinayak Jadhav 4.1.3

CA Foundation Course Elite Gurukul

Units Total Revenue Average Revenue Marginal Revenue

1 10 10 10
2 18 9 8
3 24 8 6
4 28 7 4
5 30 6 2
6 30 5 0
7 28 4 -2
8 24 3 -4
9 18 2 -6
10 10 1 -8

Relationship between AR, MR, TR and Price Elasticity of Demand

Prof. Vinayak Jadhav 4.1.4

CA Foundation Course Elite Gurukul

Prof. Vinayak Jadhav 4.1.5

CA Foundation Course Elite Gurukul
Chapter – 2 DETERMINATION OF PRICES

DETERMINATION OF PRICES - A GENERAL VIEW

In an open competitive market, it is the interaction between demand and
supply that tends to determine equilibrium price and quantity.
In an equilibrium state, the aggregate quantity that all firms wish to sell equals
the total quantity that all buyers in the market wish to buy and therefore, the
market clears. Equilibrium price or market clearing price is the price at which
the quantity demanded of a commodity equals the quantity supplied of the
commodity i.e. at this price there is no unsold stock or no unsupplied demand.

Table – 3: Determination of Price

S. No. Price (₹) Demand Units Supply (Units)
1 1 60 5
2 2 35 35
3 3 20 45
4 4 15 55
5 5 10 65

The market supply is greater than market demand and there is an excess
supply or surplus in the market. Competing sellers will lower prices in order to
clear their unsold stock.

Other things remaining constant, as price falls quantity demanded rises and
quantity supplied falls. In this process the supply-demand gap is reduced and
eventually eliminated thus restoring equilibrium.

A shortage arises as quantity demanded exceeds the quantity supplied. The

shortage prompts the price to rise, as the buyers, who are unable to obtain as
much of the good as they desire, bid the price higher. The market price tends to
increase.

CHANGES IN DEMAND AND SUPPLY

Market equilibrium was done by us under the ceteris paribus assumption.
other than price of the commodity under consideration (like income, tastes and
preferences, population, technology, prices of factors of production etc.) always
change causing shifts in demand and supply. Such shifts affect equilibrium
price and quantity.

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CA Foundation Course Elite Gurukul

i. An increase in demand:

ii. Decrease in Demand: The opposite will happen when demand falls as a result of
a fall in income, while the supply remains the same.

iii. Increase in Supply:

iv. Decrease in Supply

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CA Foundation Course Elite Gurukul

SIMULTANEOUS CHANGES IN DEMAND AND SUPPLY

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CA Foundation Course Elite Gurukul

Prof. Vinayak Jadhav 4.2.4

CA Foundation Course Elite Gurukul

Prof. Vinayak Jadhav 4.2.5

CA Foundation Course Elite Gurukul
Chapter – 2 DETERMINATION OF PRICES
Unit 3:

Prof. Vinayak Jadhav 4.3.1

CA Foundation Course Elite Gurukul

Prof. Vinayak Jadhav 4.3.2

CA Foundation Course Elite Gurukul

Prof. Vinayak Jadhav 4.3.3

CA Foundation Course Elite Gurukul

Prof. Vinayak Jadhav 4.3.4

CA Foundation Course Elite Gurukul

Prof. Vinayak Jadhav 4.3.5

CA Foundation Course Elite Gurukul
CHAPTER 5 - BUSINESS CYCLES

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.
1. Expansion (also called Boom or Upswing)
2. Peak or boom or Prosperity
3. Contraction (also called Downswing or Recession)
4. Trough or Depression

 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.
Involuntary unemployment is almost zero and whatever unemployment is
there is either frictional (i.e. due to change of jobs, or suspended work
due to strikes or due to imperfect mobility of labour) or structural (i.e.
unemployment caused due to structural changes in the economy). Prices
and costs also tend to rise faster.

 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.

 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.

 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.

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CA Foundation Course Elite Gurukul
 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. Pervasive unemployment forces the
workers to accept wages lower than the prevailing rates. The producers
anticipate lower costs and better business environment.

FEATURES OF BUSINESS CYCLES

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.

CAUSES OF BUSINESS CYCLES

Internal Causes:
 Fluctuations in Effective Demand
 Fluctuations in Investment
 Variations in government spending
 Macroeconomic policies
 Money Supply
 Psychological factors

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CA Foundation Course Elite Gurukul
External Causes:
 War
 Post War Reconstruction
 Technology shock
 Natural Factors
 Population growth

RELEVANCE OF BUSINESS CYCLES IN BUSINESS DECISION MAKING

Prof. Vinayak Jadhav 5.3