Micro Economic I

Content Page

Unit 1 Introduction to Economic Analysis...................................................................................1

Unit 2 Utility Analysis .................................................................................................................10

Unit 3 Indifference Curve Analysis..............................................................................................22

Unit 4 Theory of Demand...........................................................................................................37

Unit 5 Elasticity of Demand..........................................................................................................44

Unit 6 Production Function...........................................................................................................54

Unit 7 Neo-Classical Production Function...................................................................................62

Unit 8 Laws of Returns to Scale...................................................................................................70

Unit 9 Cost Analysis.....................................................................................................................79

Unit 10 Revenue Analysis.............................................................................................................93

Unit 11 Equilibrium of the Firm...................................................................................................106

Unit 12 The Market and Price Determination...............................................................................115

Unit 13 Perfect Competition.........................................................................................................131

Unit 14 Monopoly and Imperfect Competition............................................................................143

Unit 1: INTRODUCTION TO ECONOMIC ANALYSIS

Contents
1.0 Aims and Objectives
1.1 Introduction
1.2 Inductive Vs Deductive Method
1.2.1 Inductive Method
1.2.2 Deductive Method
1.3. Normative Vs Positive Economics
1.3.1 Normative Economics
1.3.2 Positive Economics
1.4 Micro Vs Macro Economics
1.4.1 Micro Economics
1.4.2 Macro Economics
1.4.3 Interdependence
1.5 Partial Equilibrium Vs General Equilibrium
1.5.1 Partial Equilibrium
1.5.2 General Equilibrium
1.6 Static Vs Dynamic Analysis
1.6.1 Economic Statics
1.6.2 Economic Dynamics
1.6.3 Distinction between Statics and Dynamics
1.7 Summary
1.8 Answers to Check Your Progress Exercise
1.9 Model Examination Questions
1.10 References

1.0 AIMS AND OBJECTIVES

This unit aims at providing information on how an economy works, and the various methods of economic
systems.
After reading this unit, you will be able to:
 Distinguish deductive and inductive methods
 explain positive and normative economics
 Distinguish between micro and macro economics.

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 1.1 INTRODUCTION

We have introduced in Introduction to Economics what economics is all about. This is an extension of
that course. In this unit an attempt is made to explain the basics of Microeconomics. Analysis is a logical
process of discovering truth. In formulating its principles, every science depends on a specific
methodology. Methodology in economics has been a controversial issue. Since economics is more or less
treated as science, the writers on economics are interested in the following economic analysis.

1.2 INDUCTIVE VS DEDUCTIVE METHOD

Economists follow mainly two methods for their economic analysis

I) Inductive method, and
II). Deductive method

1.2.1 Inductive Method

This is also known as empirical or historical method. It was strongly advocated and used by economists
belonging to the Historical School. This technique is a practical approach to the problems of economic
science. It reduces the gap between theory and practice. In so doing, proceeds from the particular to the
general. It has the following two forms.

i) Experimentation Approach
This approach has limited scope in economics, but it is indispensable in the case of physical and natural
sciences. As an economic phenomenon is less exact and random in nature, it doesn't possess a wide scope.
Human beings both individually and socially do not always behave in a particular way and their behavior
is not only influenced by economic factors but also by political, social, psychological cultural, and
climatic factors. This, however, does not mean that there is no place at all for experimentation in
economics. As events will not recur in the same way, the scope for experimentation is less. For example,
a war may produce certain economic side effects, but it may not recur in the same way and economists
cannot predict all the issues related to it as a pure scientist does. They may not be able to predict in the
same manner the pure scientist does. Experimentation may be carried out in economics to find out the
validity of certain laws: the law of diminishing returns, elasticity of demand and supply etc.

ii) Statistical Approach

This approach has more scope in economic analysis than experimentation. The statistical approach form
of induction was mostly advocated by the German Economists of the Historical School. Therefore, to test
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hypothesis or establish a correlation between economic facts, statistical tools may be used. Recently,
Econometrics has acquired importance for empirically testing economic theories, and their assumptions.
Advantages:
1. Economic laws, which are arrived at by a process of inductions from a set of carefully collected
facts, generally lead to precise and measurable conclusions
2. Some of the important theorems whether in social or physical sciences have been discovered as a
result of the use of induction.
3. It emphasizes the important fact that any generalization will have validity only under certain
conditions.
Limitations:
1. There is a risk of hurried conclusions being drawn from inadequate number of facts.
2. The collection of facts itself is a difficult job.
3. Induction taken alone would not do the trick unless it is supplemented by a process of deductive
reasoning.

1.2.2 Deductive Method

Deduction means the process of drawing generalizations through a process of reasoning on the basis of
some assumptions, which are either self evident or based on observation. It is also known as the
analytical, abstract and "a priori" method of inquiry for the analysis of economic problems. The classical
and neo-classical economists widely used this method. In this method, we proceed from the general to the
particular. It deduces conclusions from certain fundamental assumptions. This method is called
hypothetical, because some of the assumptions may not correspond to facts. It is also called 'abstract' '
because a certain problem is simplified, removing all irrelevant facts.
The deductive process as used by economists involves a number of steps e.g. the exploration of the
problem, building up of hypothesis, development of hypothesis and verification of theories. The first part
of deduction is the exploration of the problem; then the task is to take certain assumptions on the basis of
which some definite conclusions can be drawn. For example, consider the law of diminishing marginal
utility. The law says that the utility derived by an individual from a commodity goes on diminishing with
every successive increment of the units truth. From this self-evident truth, we can derive many
generalizations as a result of deductive reasoning. The law says that the larger the stock of a commodity,
the lower is the utility derived from it. The larger the stock of money that a person has, the lower the
utility that he derives from it. In the formulation of hypothesis, imagination and insight work along with
the fact of the phenomenon. A hypothesis in economics may study the causal relationship among various
factors, which effect the particular situation. E.g. Labor supply is a function of real wage as assumed by
classical economists, or small farms are more productive than the large farms and so on. The next task is
empirically verifying the hypothesis. If the predictions of a hypothesis are falsified, the hypothesis will be
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rejected. However, a fully controlled empiricism is difficult in economics. The next task is verification of
the theory. Verification is done on the basis of experience of facts through empiricism by means of
statistical studies. The deductive method has several advantages as its use is very simple affair and it does
not require elaborate experimentation. This method results in accuracy and exactness in generalization as
it invariably makes use of logic and mathematics. At the same time this method suffers from certain
disadvantages.

Disadvantages:
1. The generalizations arrived at as a result of deductive reasoning can be true only if the assumptions
upon which they are based hold true.
2. If the economists were to confine themselves exclusively to the method of abstraction, there is very
danger of their efforts resulting in the production of wasteful intellectual exercises.
3. This method proves particularly dangerous when universal validity is claimed for economic
generalizations on the basis of deductive reasoning.

Exercise 1
1. What are the advantages of inductive method?
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1.3 NORMATIVE VS POSITIVE ECONOMICS

1.3.1 Normative Economics

This is also known as welfare economics. It is concerned with "what ought to be" rather than with what
actually is. It provides economic policies. It is based on our judgments about what is good and what is
bad. Hence, it is mixed up with our philosophical, cultural and religious positions. It is based on our value
judgments. The welfare economics is concerned with the well being of seasons as consumers and
producers. A normative economist more pleads for prohibition of ethical grounds even though the Federal
Government may be losing revenue. The important task of normative economics is to define an ideal
economy, an economy that can give maximum satisfaction to individuals form the available resources.

1.3.2 Positive Economics

Positive economics focuses on how the economic system works. Here, we are concerned with observing
the world as it is. A greater part of economics is of this kind. Positive economics attempts to describe and
analyze the existing situation rather than suggesting how to change it. It is based on ethical
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considerations. It seeks to explain and predict the economic phenomena. For example, we may be
interested in increasing the revenue of the Federal Government, and therefore the production of alcohol
may be encouraged. The positive economists will not be seriously bothered as to whether the production
of intoxicants will be detrimental to the interest of the people or not. They are merely interested in
seeking the ways and means by which the total revenue can be increased.

Exercise -2
1. What is the subject matter of normative economics?
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1.4 Micro and Macro Economics

1.4.1 Micro Economics

It is the study of particular firms, household, and commodities. It is concerned with what determines the
prices of individual goods. Microeconomics theory examines how a consumer spends his or her income to
maximize production costs and maximize profits, how a particular form of market structure (perfect
competition, monopoly, monopolistic competition, and oligopoly) arises and how each affects the well-
being of the society, how the pricing and employment of resources or inputs are determined, and how
government can increase the well-being of society by taxes and subsidies. As small objects get
magnified under the microscope, in micro economic theory, we study all the facts of problems like the
behavior of a consumer, equilibrium of a firm, price discrimination in a single market, which are small
when compared to wholesale business, populations, in general etc.

1.4.2 Macro Economics

Macroeconomics looks at the economy as a whole. It is concerned with the overall performance of the
economic system rather than individual parts. It deals with total aggregates e.g. total national income,
total employment, output and total investment. It is aggregative economics, which studies the
interrelations among various aggregates and examines their nature and behavior, their determination and
causes of fluctuation. It deals with economic affairs in general. Instead of studying the prices of
individual commodities, it is concerned with general price level. Similarly, the level of employment in the
economy, and the aggregate investments are all macro economic variables.

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 1.4.3 Interdependence
There is no rigid analytical demarcation between micro economics and macroeconomics. Both of them
are interdependent and interconnected. Changes in the macro economic variables ultimately affect micro
economic variables.
Thus, changes in individual output, income, and employment lead to similar changes in national output,
income, employment and vice-versa. After all, the whole consists of parts. Hence, a general theory should
integrate both the wings of analysis, as they are complementary to each other.

1.5 PARTIAL Equilibrium Vs GENERAL Equilibrium

The term equilibrium in economics has been imported from physical sciences. The concept has become
so fundamental in economics that sometimes economic analysis is described as equilibrium analysis. The
word equilibrium implies a state of balance or state of rest. In economics, equilibrium does not
necessarily mean absence of movement. In fact, the economic system would collapse if all movements in
it come to stand still. An Economic unit might be moving but at the same time it might still remain in a
state of equilibrium. There is no change in the rate of movement. For example, in an economic system, a
certain quantity of goods is produced and consumed. This it self dictates movement. But, more important
is when rates of production and consumption remain constant, it can be said that the system is in
equilibrium position. A consumer will be in equilibrium when he derives maximum satisfaction from a
given income spent on different goods and services. Once he reaches equilibrium position, he sticks to it
because any change in allocation of income to different goods and services will reduce his total
satisfaction.

1.5.1 Partial Equilibrium

This is an economic analysis where we isolate a particular activity for a special investigation, separate
from other types, even though there is interdependence among the various types of activities. Under
partial analysis we investigate in great depth, for example, the behavior of the consumer, the producer, the
factor of production or the monopoly market. In each case, we assume that everything is constant, only
one segment of the total market is allowed to change. For example, when we discuss the relationship
between price and quantity demand of a commodity, we assume that the prices of substitute commodities,
incomes and tastes of consumer are constant. For example, in production functions analysis, where the
total product depends on labor and capital, When we consider an increase in production, the capital is
held constant and labor is allowed to vary. The reason for assuming all other things remaining constant is
that if we do not assume like that, the analysis of the problem would become an exceedingly difficult
affair.

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 1.5.2 General Equilibrium
General equilibrium is related to the whole system. It is concerned with the ultimate determinates of the
whole system of prices and outputs of all the goods and services produced in an economy. The general
equilibrium analysis proves that when one economic variable changes, others also change simultaneously.
For example, the price of butter is increased. Partial equilibrium analysis tells us that reduced quantity of
batter will be bought and the mater ends there. But when other factors that influence the demand for
butter are also taken into account, the above result may, or may not follow. The quantity demanded for
margarine, which is a substitute for butter, will rise and consequently its price will also rise. The quantity
demanded of the complementary goods such as bread and Jam will decrease and consequently their prices
will fall. If less is spent on bread and butter, more may be spent on clothes. If the clothes producer obeys
the law of decreasing cost, its price may fall resulting in increased demand for cloth. These changes in the
consumer goods sector of the economy will cause factor shifts causing consequent changes in producer
sector. Labor and capital will be withdrawn from bread and butter making industries, while more labor
and capital will be employed in the cotton textile industries. Consequently, the increased demand for
cotton will change the land use from food grains cultivation to cotton. All this will change the factor
incomes and their demand. Further changes will therefore take place in the demand for consumer goods
and their prices and so on. In this way, general equilibrium presents an overall framework of basic price,
out put interrelationships for the entire economy including both commodities and factors of production.
Taking the interdependence between all the prices, these can be determined mathematically in a market
economy.

1.6 STATIC Vs DYNAMIC ANALYSIS

It is Auguste, a famous French Sociologist, who introduced for the first time the concepts "Statics and
dynamics" in the domain of social sciences.

1.6.1 Economic Statics

The term 'Static' in physical science is indicative of a position of rest or absence of any movement. It does
not indicate a motionless economy in economics. There is movement in the economy but this movement
is constant, regular, smooth and certain and without, any sudden jerks. By static relationship, we mean a
relationship between certain variables which relate to the same point of time and hence, this analysis
excludes time. "Static" in economics is not a state of idleness, but one where work proceeds smoothly at a
steady pace day by day and year after year in the economy.

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 1.6.2 Economic Dynamics
This studies economic changes over time. It refers to a state where the rates of output are changing. Hicks
defines that economic dynamics is that part of economic theory in which every quantity must be dated.
But Harrod, another economist, does not agree with Hicks when he says that in dynamics dating is no
more required. But it is the essence of dynamics that economic variable works on another variable. Again
certain variables depend on the rate of growth of other variables. The essential feature of dynamic theory
is that we have to consider not only a set of magnitudes of a given point of time and the study of the
interrelationships between them, but, also the magnitude of certain variables at different points of time.

1.6.3. Distinction between Static and Dynamics

1. Statics is the study of relations between economic variables at a point of time. Economic dynamics
studies the relationships between variables over time.
2. In statics, there is movement but no change of economic phenomena. But in dynamics the fundamental
elements change.
3. Statics studies the movement around the point of equilibrium, but dynamics traces the path from one
point of equilibrium to another.

1.7 SUMMARY

Every science follows its own methodology for analysis. There are deductive and inductive methods in
economics. Positive economics studies the working of existing economic system. It is concerned with
"what actually is" whereas "what ought to be" is dealt with by normative economics. It is based on value
judgment. Economic analysis has two branches: micro and macroeconomics. Micro economics deals with
individuals, households, firms, industries or prices of different commodities as a unit of a study. On the
other hand, Macro economics studies the economy as a whole.

1.8 ANSWERS TO CHECK YOUR PROGRESS EXERCISES

1. The following are the limitations

i) There is a risk of hasty conclusions drawn from inadequate facts
ii) Collection of fact itself is a difficult job.
iii) Induction taken alone would not do the trick unless it is supplemented by a process of deductive
reasoning.
2. Microeconomics is the study of elements of economic activity-the firm and the consumer. It takes into
account individuals, households, firms, industries or prices of different commodities as the unit of
study.
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1.9 MODEL EXAMINATION QUESTIONS

1. Distinguish between inductive and deductive methods.

2. Explain the relationship between micro economics and macroeconomics.
3. What is meant by normative and positive economics?
4. Explain two approaches in inductive method.
5. What are the limitations of deductive method?
6. Explain general and partial equilibrium?

1.10 REFERENCES

 Varian. R Hall (1999) Intermediate microeconomics.

 Koutseyianniss A (1985) Modem microeconomics.
 Gonld and Furguson (1985) microeconomic theory.
 Jhingan, M.L (1998) microeconomic theory.
 Barthwal, R.R (1992) microeconomic theory.

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UNIT 2: UTILITY ANALYSIS

Contents
2.0 Aims and Objectives
2.1 Introduction
2.2 Approaches to Utility Analysis
2.3 The Cardinal Utility Theory
2.4 The Law of Diminishing Marginal Utility
2.5 The Law of Equi-Marginal Utility
2.6 Consumer Surplus
2.7 Summary
2.8 Answers to Check Your Progress Exercises
2.9 Model Examination Questions
2.10 References

2.0 AIMS AND OBJECTIVES

The unit discusses the approaches to utility analysis and presents the meaning and Law of diminishing
marginal utility. The unit also presents the meaning of consumer surplus.
After reading this unit, you will be able to:
 Explain and the meaning of utility
 explain the law of diminishing marginal utility and its limitations;
 distinguish between cardinal and ordinal approaches to utility analysis;
 Understand consumer surplus. .

2.1 INTRODUCTION

Consumers satisfy their wants through the consumption of goods and services. Goods are defined as
things that have the ability to satisfy a need. Economists call the want satisfying property of goods as
utility. In fact, when a consumer buys goods, it is not the goods that are desired but the utility that he
derives from the goods. Goods are demanded by consumers for their ability to satisfy wants However, the
want-satisfying power or utility is not inherent in goods. Goods posses utility. For example, diamonds are
like pebbles, but as we attach importance to the possession of this scarce good, they have a very high
value in capitalist societies. But water, which is essential to life and, therefore, to be considered of very

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great utility commands only a very low and often no more than zero price. This is so because, a particular
type of good will have more utility for some people than it will have for others. Furthermore, for a given
individual, a particular type of good will have differing amounts of utility, depending upon the amount
consumed. For example, when an individual is hungry, he will be inclined to consume food, which has a
high utility for him at the time. But when he is asked to consume again, he may not be consuming the
same quantity and the utility will be also low. Thus, utility of a particular good will vary as the quantity'
consumed varies. Therefore, in technical sense, each unit of a particular good is distinct from each other.

The consumer is assumed to be rational. Given his income and the market prices of various commodities,
he plans the spending of his income so as to attain the highest possible satisfaction or utility to him. This
is the axiom of utility maximization. In the theory of consumption, it is assumed that the consumer has
full knowledge of all the information relevant to his decision i.e., he has complete knowledge of all the
available commodities, their prices, and his income.

2.2 APPROACHES TO UTILITY ANALYSIS

There are two basic approaches to the problem of comparison of utilities. These are;
(1) Cardinalist approach, and
(2) Ordinalist approach.
The Cardinalist Approach assumes that utility can be measured. Some economists suggest that utility can
be measured in monetary units, i.e., by the amount of money the consumer is willing to sacrifice for
another unit of a commodity. Others suggest that utility can be measured in subjective units called 'Utils'.
This approach is advocated by Gossen (1854), Jevons (1871) and Walras (1874), and Aifred Marshall
(1890).
On the other hand, the ordinal school maintained that utility is not measurable, but it is only comparable.
The consumer need not know in specific units the utility of various baskets of goods according to the
satisfaction each basket gives him. The consumer would be able to determine his order of preference
among the different baskets of goods.
Hicks and R.JD. Allen are the main supporters of the ordinal school. The main ordinal theories are the
indifference curve approach and the revealed preference approach.

Exercise -1
1. What is meant by cardinal approach to utility?
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 2. What does the term ordinal approach to utility mean
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2.3 THE CARDINAL UTILITY THEORY ASSUMPTION

The following are the assumptions behind the cardinal utility approach.
a) Rationality: The consumer is rational. It means he aims at the maximization of his utility subject to the
constraint imposed by his income.
b) Utility is Measurable: The utility of each commodity is measurable. The most convenient measure is
money. The utility is measured by the monetary units that the consumer is prepared to pay for another
unit of the commodity.
c) Constant Marginal Utility of Money: This assumption is essential if the monetary unit is used as the
measure of utility. The essential feature of a standard unit of measurement is that it must be constant.
d) Diminishing Marginal Utility: The utility gained from successive unit of a commodity goes on
diminishing as the consumer acquires larger quantities of it.
e) The total utility of "a basket of goods" depends on the quantities of the individual commodities. If there
are ‘n' commodities in the bundle with quantities XI,X2 xn, the total utility is
U = f (Xl, X2...,xn)
Equilibrium of the Consumer
Let us take a single commodity X. The consumer can either buy ‘X’ or retain his money income 'Y'.
Under these conditions, the consumer is in equilibrium .When the marginal utility of "X" is equated to its
market Price (Px),symbolically we have
Mux = Px
If the marginal utility of 'X' is greater than its price, the consumer can increase his welfare by purchasing
more units of 'X'. Similarly, if the marginal utility of 'X' is less than its price, the consumer can increase
his total satisfaction by cutting down the quantity of 'X' and keeping more of his income unspent. Hence,
he attains the maximization of his utility when MU x = px. If there is more than one commodity, the
condition for the equilibrium of the consumer is the equality of the ratios of the marginal utilities of the
individual commodities to their prices. Symbolically,
Mux = Muy = MUn
Px Py Pn
The utility from spending an additional unit of money must be the same for all commodities. If the
consumer derives greater utility on anyone commodity, he increases his welfare by spending more on that
commodity and less on the other commodities, until the above equilibrium condition is fulfilled.
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2.4 LAW OF DIMINISHING MARGINAL UTILITY

This is one of the important laws in consumption theory. According to this law, as a person purchases
more and more units of a commodity, its marginal utility declines. In other words, the more we have of a
commodity, the less we want to have some more of it. It is the practical experience of every consumer
that as he goes on consuming a particular commodity, each successive unit gives less and less utility. The
law points out that the marginal utility of a commodity depends upon its quantity but is not proportional
to its quantity. The marginal utility of the commodity to the consumer depends upon the volume of the
stock purchased or possessed already by him. The larger the volume possessed or bought by him, the
smaller the utility derived from an additional unit of the commodity.

Alfred Marshall defined diminishing (marginal) utility as "the additional benefit which a person derives
from a given increase of his stock of a thing, diminishes with increase in the stock that he already has.
The above law can be explained with the help of a simple example. The following table relating to
imaginary consumer consuming bananas illustrates the law clearly.
Table-2.1: Total and Marginal Utilities (in units)

Number of Total Marginal

Bananas Utility Utility
1 15 15
2 25 10
3 30 5
4 30 0
5 25 -5
6 15 -10

From table 2.1 it is clear that as the consumer goes on eating bananas, the additional of marginal utility
goes on decreasing. The 4th banana gives no additional utility and the 5 th and 6th bananas have a negative
utility. Their consumption, instead of giving satisfaction, causes dissatisfaction. If we look at column 2,
we will find that the total utility goes on increasing up to a point. It also seems reasonable that the utility
of two bananas should be more than that of one and so on. But if we look at that more carefully, we will
notice that although the total utility does increase, it increases only at a diminishing rate. In the above
table, when the consumer eats the second banana, the increase in utility is 10 units and when he eats the
third, the total utility increases by 5 only. This can be explained with the help of the following diagram
Diagrammatic Representation

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In diagram 2.1 'OX' axis represents the units of the commodity, i.e. Bananas, and along 'OY' axis is
measured the total and marginal utilities. The total utility curve 'UT' indicates that total utility increases as
the consumption of bananas increases. But the increase is at a decreasing rate. So the marginal utility
decreases. At a certain level, increasing consumption of bananas may not push the total utility up. In the
diagram, at point 'N' the total utility is the highest where the marginal utility is zero. After that the total
utility also decreases, and then marginal utility becomes negative. In the diagram, the marginal utility is
represented by 'UM'. The straight lines represent the utility of the various units of the commodity. The
'AU' straight line represents the largest area because the utility of the first unit is the maximum. But the
successive straight lines 'BD', CE' are smaller according to the operation of the law: At the 4th banana
(point F) is no addition to the total utility, i.e., the marginal utility is zero. And afterwards, the marginal
utility is negative and is represented below the 'OX' axis. The marginal utility curve 'UM' is sloping
downwards to the right because with every increase in the quantity of the commodity consumed, the
marginal utility declines.

Assumptions
The law of diminishing marginal utility is based on three important assumptions. These are
1. The tastes and preferences of the consumer do not change during the period of consumption.

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2. The units of the commodity are homogeneous i.e., they are same in size and quality, and
3. There is no time gap between the consumption of the two units of the commodity. In other words, the
process of consumption should be continuous without an interval.

Limitations or Exceptions
1. The 1aw does not apply in the case of rare collections like stamps, paintings, and corns, etc. In
the case of rare collections, the larger the number of collections, the greater will be the
pleasure. Hence, the law does not apply.
2. The law applies only to normal persons. But there are some abnormal persons, too e.g., misers,
drunkards, etc. The more money a miser has, the greater the utility he derives. The more the
drunkard gets pleasure, the more he drinks.

Importance/Advantages
The law of diminishing marginal utility expresses a basic principle of man's behavior. It is of great
practical value to human beings in every walk of life.
1. The law is applied in the sphere of taxation. A rich man is taxed more, for the utility of money to a rich
man is less than that of a poor man. The principle of progressive taxation is based on this only.
2. The law can also be applied in determining the prices of goods in the market. An increase in the stock
of a commodity brings a person less satisfaction and therefore he can be induced to buy more only if
the price is lowered. Hence, the greater the supply, the lower the price to clear it, and vice-versa.
3. The law regulates our daily expenditure pattern. We know that as we go on buying more of a
commodity, its marginal utility declines. Having only a limited amount of money at our disposal, we
do not want to waste it unnecessarily on the purchase of the same commodity in large quantity. We,
therefore, stop purchasing it at a point where the utility of money spent is equal to the last unit of the
good purchased. We spend the rest of our money on other goods.
4. The marginal utility analysis of pricing and the diminishing marginal utility can quickly dispose of the
diamond-water paradox. With the help of this analysis, we can now explain that the relative scarcity of
diamonds results in high price, while the relative abundance of water means that its marginal utility
and consequently its price will be low despite its high total utility.

2.5 THE LAW OF EQUI-MARGINAL UTILITY

This is another important law in consumption theory. It is also known as the Law of substitution or the
equi-marginal principle. It further designated is as the Second Law of Gossen an Austerian economist
who proposed it.(the law of diminishing marginal utility being Gossen's First Law), As human wants are
unlimited and the resources to satisfy them are limited, every rational consumer, therefore, will try to
15
make the best use of the money at his disposal and derive the maximum satisfaction. In the words of
Alfred Marshall, if a person has a thing, which can be put to several uses, he will distribute it among these
uses in such a way that it has the same marginal utility, for if it had a greater marginal utility in one use
than in another, he would gain by taking away some of it from the second use and applying it to the first.

We carefully go on weighing the satisfaction obtained from each Birr that we spend f or getting maximum
satisfaction out of the money at our disposal. If we find that a Birr spent on one commodity had greater
utility than in another, we shall go on spending more Birr on the former commodities. This continues till
the utilities derived from the last Birr spend in the two cases are equal. It means, we substitute some units
of a commodity of greater utility for some units of lesser utility. As a result of this substitution, the
marginal utility of the former will fall and that of the latter will rise till the two marginal utilities are
equalized. Hence, this is called the law of Substitution. The following imaginary schedule provide us with
the marginal utilities of two commodities i.e.,' "X' and 'Y’.

Table 2.2: Marginal Utilities of Commodities ’X’ and’Y’

Marginal Utility Marginal Utility

Money Units
Of ‘X’ Of ‘Y’
1st Birr 10 8
2nd Birr 8 6
3rd Birr 6 4
4th Birr 4 2
5th Birr 2 0
6th Birr 0 -2
7th Birr -2 -4

In the above table, we are assuming that the consumer has Birr 7 at his disposal to spend on two
commodities "X' and "Y'. The two utility schedules indicate that the consumer's preference for
commodity 'X' is more marked since he seems to receive more utility from his consumption of "X' than
from 'Y'. If he spends his whole income of Birr on commodity 'X' alone, he will secure a total satisfaction
equivalent to 28 units, while if he spends his entire income on 'Y’ alone, he will secure only 14 units of
utility. But the consumer will not, however, spend his entire money income on one commodity alone. The
normal consumer behavior pattern shows that people do not specialize in consumption. he wants to get
maximum satisfaction, the consumer will continue to distribute his limited income on both goods till the
marginal utilities, a Birr worth of purchase of the two goods, are equal. From the above utility schedules,
we can see that the maximum satisfaction will be attained if the consumer spends Birr 4 on 'X' and Birr 3

16
on 'Y'. The maximum satisfaction will be about 46. Now, the marginal utility of both commodities 'X' and
'Y' is same i.e., 4. Thus, we can conclude that we can attain maximum satisfaction when we equalize
marginal utilities by substituting the more useful commodity for the less useful one.

Diagrammatic Representation
In the two figures given below, we take money units on 'OX' axis and marginal utilities of two goods on
'OY' axis. Suppose a consumer has Birr 7 to spend on 'X' and 'Y' whose diminishing marginal utilities are
shown by the two curves' AP', and 'OR', respectively. The consumer will gain maximum satisfaction if he
spends 'OM' money on Y and 'OM' on X (4 Birr) ,because in this way the marginal utilities of the two are
equal (PM = PM'). Any other arrangement will give less than total satisfaction. Let the purchaser spend
MN money (one Birr more on X and the same amount of money N'M' (=MN) less on Y. diagram 2.2
shows a loss of utility represented by the shaded area LN'M'P' and a gain of PMNE utility. As MN = N'M
and PM = P'M' it is proved that the

of

Figure LN1M1P1(loss of utility from reduced consumption of oranges) is bigger than PMNE (gain of
utility from increased consumption of appeals). hence, the total utility of this combinations will give
maximum satisfaction.
Limitations
1. The law is based upon the assumption that a man acts in a perfectly rational manner when he spends his
money-income on a number of different commodities. If the consumer is ignorant or blindly allows
custom or fashion, he will make a long use of money. On account of his ignorance, he may not know
where utility is greater and where it is less.
2. An incompetent entrepreneur will fall to achieve the best result from the units of land, labor and
capital that he employs. This is so because he will not be able to divert expenditure from less profitable
channels to more profitable ones.
3. The law does not apply in cases where the resources are unlimited as for example, in case of free gifts
of nature. In such cases, there is no need of diverting expenditure from one direction to another. We
17
 have been employing all the way through our analysis a monetary measure of marginal utility to make
our comparison between the price of a commodity and its marginal utility. The marginal utility of X in
money terms was defined as the maximum amount of money, which the consumer is willing to pay for
an additional unit of X. But the marginal utility theorists were generally dissatisfied with such a
measure. Because when money becomes scarcer, they maintained, its subjective marginal value will
increase, like that of any commodity. Marginal utility must, according to this view, be measured in its
own subjective units. We may call them utile. The view can be referred to as the neo-classical cardinal
utility position. One index that had been developed in this direction which is called N- M index is
cardinal. It is intended to be used for making predictions. It is employed to predict which of two risky
alternatives a person will prefer. For example, if he has to choose between two lottery tickets, we are
given this individual's ranking of the alternative prizes offered by the lottery tickets and the odds on
each prize. From this we wish to be able to infer by numerical calculation, and without actually asking
the person, which lottery ticket he will choose. Even though, by a numerical N-M utility index, we can
compute numerical marginal utilities and some of the other measures encountered in neo-classical
utility theory, it is surely not cardinal measurement in the neo-classical sense.

2.6 THE CONSUMERS’ SURPLUS

The concept of consumers' surplus was introduced in economics by Alfred Marshall, who maintained that
it can be measured in monetary units. In our everyday life, we often find that the price we pay for a
commodity is usually less than the satisfaction we derive from its consumption. Sometimes we will be
prepared to pay much more for a commodity than we actually pay. Consumers' surplus is equal to the
difference between the amount of money that a consumer actually pays to buy a certain quantity of a
commodity 'X' and the amount that he would be willing to pay for this quantity rather than do without it.
In some of the items of our daily expenditure, the idea of consumers' surplus is quite obvious e.g., a
packet of salt, a post-card, a newspaper, a matchbox etc. They are very useful commodities but at the
same time, they are also very cheap. We are, therefore, prepared to pay much more for them, if need be,
than we actually have to pay. For their purchase, therefore, we derive a good deal of surplus or extra
satisfaction over and above the price that we pay for them. Consumers’ surplus can be represented
mathematically as follows:
Consumers' surplus = Total utility -Total amount spent

18
The following table illustrates the concept of the consumers' Surplus
Units(Apples in Marginal Price Consumers’
Dozen) Utility (in birr) Surplus
1 2 3 4
1 20 5 15
2 18 5 13
3 15 5 10
4 11 5 6
5 5 5 0
Total Units Total Total Money
Purchased 5 Utility 69 spent 25 44

In the above table, it is assumed that the price of apples in the market is Br. 5 per dozen. The consumer
will to purchase, as many apples as will make his marginal utility equal to the price. Thus, he will
purchase 5 dozens of apples and pay for each dozer Br. 5. Totally, he spends Br. 25 But his total utility
from 5 dozens apples is equal to Br. 69. He, thus, gets a consumers' surplus equal to Br. 69 -25 = Br. 44.
The consumers' surplus can be found out from the fourth column of the table. From the first dozen of
apples, the consumer gets utility equal to Br. 20. Hence, the consumer would be ready to pay Br. 20 for it
rather than to go without it. However, the consumer pays only Br. 5 for the first dozen because the price
of orange in the market is only Br. 5. Therefore, from the first dozen, he gets consumers' surplus equal to
20 -5 = 15. Similarly, he gets Br. 13, Br. 10 and Br. 6 consumers' surpluses on the second, third and
fourth units. From the fifth unit, the consumer derives utility equal to 5 and he also pays Br. 5 for it. Thus,
there is no consumers' surplus on the fifth unit. The total consumers' surplus is equal Br to 44 .We can
also represent consumers' Surplus with the help of a diagram.

Diagrammatic Representation of Consumers’ Surplus

In the following diagram, the units of the commodity are measured along 'OX' axis and marginal utility
in terms of money is measured along 'OY' axis.
Y
Graphically, the consumers' surplus is found on this demand
U curve for commodity X and the current market price, which
A1 P1

the consumer cannot affect by his purchase. In the diagram;

2
A P the consumers demand curve for 'X' is a straight line
P11
0 M1 M U1 UU1and the market price is ‘A’. Y

Fig 2.3 Goods

At this price, the consumer buys 'M' units of X and pays an amount AXM for it. However, he would be
willing to pay p1 for P2 for M2 and for P3 for M3 and so on. The fact that the price in the market is lower
than the price he would be willing to pay for the initial units of 'X' implies that his actual expenditure is
19
less than he would be willing to spend to acquire the quantity 'M'. This difference is called the consumer's
surplus and it is represented by the area of the 'PUA'.

Check Your Progress -2

1. What is consumer surplus?

____________

2.7 SUMMARY

This unit covered one of the approaches of utility analysis, cardinalist approach. In this, the consumer gets
the equilibrium when the price of a commodity is equal to the additional benefit i.e. marginal utility he
derives from consuming that commodity. This condition is applied even if there is more than one
commodity. The law of diminishing marginal utility states that if you consume more of a commodity
without time gap, the marginal utility you get from that commodity goes on declining. Another theory
presented is equi-marginal utility.

2.8 ANSWER TO CHECK YOUR PROGRESS EXERCISE

1. Cardinal approach assumes that utility can be measured in terms of monetary units.
2. The utility can be measured in subjective units called ‘utils'
3. The consumers surplus may be defined as the difference between what we are prepared to pay minus
what we have exactly paid.

2.9 MODEL EXAMINATION QUESTIONS

1. What is marginal utility in general and equi-marginal utility in particular?

2. What do we mean by consumers surplus?
3. Represent consumers surplus diagrammatically.
4. How do you derive consumer equilibrium in the cardinal utility approach.
5. Explain the law of diminishing marginal utility with the help of a diagram

20
2.10 REFERENCES

 Dominick Salvatore (1986) Micro Economics Theory and application

 Varian. R Hall (1999) Intermediate microeconomics.
 Koutseyianniss A (1985) Modern microeconomics.
 Gonld and Furguson (1985) microeconomic theory.
 Jhingan, M.L (1998) microeconomic theory.
 Barthwal, R.R (1992) microeconomic theory.

21
UNIT 3: INDIFFERENCE CURVE THEORY

Contents
3.0 Aims and Objectives
3.1 Introduction to Ordinal Utility Approaches
3.2 What are Indifference Curves?
3.3 Assumptions Behind Indifference Curve Analysis
3.4 Properties of Indifference Curves
3. 5 Consumer's Equilibrium
3.6 Income, Substitution and Price Effects
3.7 Derivation of Demand Curve from Indifference Curve
3.8 Summary
3.9 Answers to Check Your Progress Exercise
3.10 Model Examination Questions
3.11 References

3.0 AIMS AND OBJECTIVES

The purpose of this unit is to explain the ordinal utility approach.

After studying this unit, you will be able to:
 recognize the importance of Ordinal Utility Theory;
 list the properties of indifference curves;
 explain consumer equation.

3.1 INTRODUCTION TO ORDINAL UTILITY APPROACH.

In the study of marginal utility analysis, we have assumed that utility is measurable in the cardinal sense.
To overcome this difficulty, modern economists have developed an alternative approach of indifference
curve analysis based on ordinal measurement of utility. This is in recognition of the fact that exact
measurement of utility is not possible and that the economists can at best give a ranking to consumer's
satisfaction instead of measuring it in units. The N-M index is also ordinal in its approach even though it
seems to be using the cardinal approach. In the ordinal approach, the consumer need not assign specific
amounts to the utility, which he derives from the consumption of a good combination of goods. He will
simply compare the different utilities or satisfaction in the sense whether one level of satisfaction is equal
to, lower than, or higher than another. For example, if the various combinations are X, Y, Z etc., the

22
consumer can tell whether he prefers X to Y or Y to Z or is indifferent to the comparing of them. The
concept of ordinal utility implies that the consumer cannot go beyond stating his preference or if
indifference. In other words, if a consumer happens to prefer X to Y, he cannot precisely tell by how
much he prefers X to Y or he cannot tell the quantitative differences between
various levels of satisfaction. At the most he can merely judge whether one level of satisfaction is higher
than or lower than or equal to another or alternatively rank his preferences as 1 st, 2nd, 3rd and so on. For
example, suppose the individual consumer is consuming rice and clothing. The indifference curve
analysis indicates that he would be consuming both This is works as follows: his level of satisfaction
would be the same if he consumes less of rice and more of clothing or more of rice and less of clothing as
it long as remains on the same indifference curve.

Exercises-1.
1. What is ordinal utility analysis
________________________________________________________________________________
________________________________________________________________________________
________________________________________________________________________________

3:2 WHAT ARE INDIFFERENCE CURVES?

To understand indifference curves, it is better to start with an indifference schedule.

Table 3.1: Indifference Schedule

Schedule-I Schedule-II
Goods ‘X’ Goods’Y’ Goods’X’ Goods ‘Y’
1 15 1 17
2 11 2 14
3 8 3 11
4 6 4 8
5 5 5 6

In the above schedules, the consumer has to start with 1 unit of X and 15 units of Y. Now the consumer is
asked to tell how much of goods he will be willing to give up for the gain of an additional unit of X so
that his level of satisfaction remains the same. If the gain of one unit compensates him fully for the loss of
4 units of Y, then the next combination of 2 units of X and II units ofY(2X + Ily) will give him as much
satisfaction as the initial combination (IX + I5Y). Similarly by asking the consumer further how much of
Y he will be prepared to fore-go for successive increments in the stock of X so that his level of

23
satisfaction remains unaltered, we get combinations of 3X + 8Y, 4X + 6Y and 5X + 5Y each of which
provides the same satisfaction as combination IX + 15Y or 2X + 11Y. Since satisfaction is the same
whichever combination of goods in the schedule is offered to him, the consumer will be indifferent
among the combinations included in a schedule.
Similarly, the consumer may have another schedule representing more of both the goods than the initial
combination Schedule-II. Once again, the consumer is indifferent among the various combinations in
Schedule-II, however it should be emphasized that the consumer will prefer any combination in Schedule-
II more than any combination in Schedule-I. The indifference schedule can be converted into indifference
curve by plotting the various combinations on a graph paper.

Fig 3.1
Thus, when there are two difference curves (I & II), combinations on indifference curve I will be of equal
value and similarly combination on the indifference curve II will be of equal value. But combinations on
the higher indifference curve will have greater value than combinations on the lower indifference curve.
The higher the indifference curve or the farther it is from the origin '0', the higher the level of satisfaction
from the combination of two commodities.

3.3 ASSUMPTIONS BEHIND INDIFFERENCE CURVE ANALYSIS

Before we discuss the properties of indifference curve, it is useful to refer to the assumption about the
psychology of the consumer, which is very relevant to indifference curve analysis.
Assumption-I
It is assumed that a consumer will also prefer more of a piece of goods to less of another if he is
oversupplied or oversatiated. With one of them he will prefer a smaller quantity, of that one to the larger
quantity. It is thus assumed that the consumer has not yet reached the point of satiety in the consumption
of any of the goods.
This assumption is therefore known as non-satiety assumption.
24
Assumption-II (Transitivity)
By transitivity, let us suppose there are three combinations of two goods, X, Y and Z. The consumer is
indifferent between combination X and Y and also between X and Z. It is obvious that by law of
transitivity, he will be indifferent between combination Y and Z which implies that consumer's tastes are
quite consistent.
Assumption-III Diminishing Marginal Rate of Substitution (MRS)
According to the principle of diminishing marginal rate of substitution, it is assumed that the consumer
will be prepared to give up less and less of good: Y for each additional unit of X. In the indifference
schedule given earlier, we have seen that in the beginning the consumer gives up 4 units of Y for the gain
in one additional unit of X, but the level of satisfaction remains the same. It follows that he gives up 3
units of Y for an additional unit of X and later on 2Y for ┴X and so on. Thus, the marginal rate of
substitution of X for Y (MRSxy) diminishes as more and more of good X is substituted for goods Y.

3.4 PROPERTIES OF INDIFFERENCE CURVES

Based on the above assumptions, we can proceed to deduce the properties of indifference curves:
a) Indifference curves slope downwards form left to right.
b) Indifference curves are convex to the origin.
c) Indifference curves cannot intersect each other.
d) A higher indifference curve represents higher level of satisfaction than the indifference curve at
the lower level.

Indifference curves slope downwards from left to right

This property implies that an indifference curve has a negative slope. This means that when the amount of
one piece of good in the combination is increased, the amount of the other good is reduced so that the loss
of satisfaction by giving up the first good is compensated for the gain the satisfaction by additional unit of
the other good. (See figure 3.1). If the indifference curves do not slope downwards form left to right, they
can be horizontal or they must slope upwards from left to right. Let us examine the horizontal
indifference curve in the outline given below.

25
 Y

Groups ‘Y’

A B C D E F
IC

X
0 1 2 3 4 5 6
Fig 3.2 Goods ‘X’

If the indifference curve had the shape of horizontal straight line as given above, it would mean that all
combinations along the curve are of equal value i.e., 4X + 1 Y, 4X+2Y, 4X+3Y and so on. But this
cannot be true if our first assumption is to hold good, i.e., a consumer always prefers a larger amount of a
good to a smaller one. Hence, each succeeding combination is better than the previous one, so much so
the consumer cannot be indifferent: he would definitely prefer a combination including a larger amount of
one commodity with the same amount of the other to a combination including a smaller amount of one
commodity with the same amount of other. Therefore, an indifference curve cannot be horizontal since
different combinations on the curve will differ in importance and satisfaction.
The other alternative to a downward sloping indifference curve would be an upward sloping indifference
curve shown below:
If the indifference curve were upward sloping to
the right it would mean that combination which
brings together more of both the goods could give
the same satisfaction to the consumer as the
combinations which had smaller amounts of both
the goods. This is clearly invalid because the
consumer would always prefer the combination
containing more of both the X goods to a
combination containing less.

Therefore, the consumer prefers the same combination

to the other. He cannot be indifferent between them. Indifference curve these cannot slope upwards to the
right because in such a case the combinations on the curve will be of different significance this is quite
26
contradictory with the property of an indifference curve. Hence, the indifference curve must necessarily
slope downwards from left to right as given below in
figure 3.4 A. The downward sloping indifference curve would mean that all combinations on the 'curve
are of equal significance and the is consumer therefore indifferent between them. For every increase in
the amount of X, there is corresponding decrease in the amount of Y.

Indifference curves are convex to the origin

The property of indifference curve being convex to the origin follows from the assumption of diminishing
marginal rate of substitution. This may be illustrated below (see figure 3.4 B)

Along OX we have made AB = BC = CD representing three equal units of commodity X. In order to get
more, the consumer will exchange X for Y. It will be clear from the above figure that as more and more
of X is acquired, for each extra unit of X the consumer is willing to part with less and less of Y i.e., MRS
xy diminishes as more and more of X is substituted. Thus, the convex indifference curves are consistent
with the principle of diminishing MRSxy. We therefore conclude that indifference curves are convex to
the origin,
If the indifference curve is concave to the origin it goes contrary to the law of diminishing marginal
utility. A concave indifference curve will imply that the MRS xy increases as more and more of X is
substituted for Y, as shown below.

27
It can be seen from the figure 3.5 that as more and more of X is acquired for each extra unit of X, the
consumer is willing to part with more and more of Y. i.e, MRS xy increases as more and more of X is
substituted for Y: Thus if the principle of diminishing marginal rate of substitution is valid, then
indifference curves cannot be concave to the origin.
Indifference curves cannot intersect each other
Indifference curves cannot intersect each other. If they should intersect, we arrive at self-contradictory or
absurd conclusions. In figure 3.6, two indifference curves are shown cutting each other at point C.

Taking IC2 No. 1 first

OM of X + OS of Y = ON of X + OR of Y

28
Taking IC1 No.2
OM of X + OS of Y = ON of X + OQ of Y Therefore OR of Y = OQ of Y
Hence, On of X + OR of Y = ON of X + OQ of Y, but the conclusion that OR of Y = OQ of Y is absurd.
The fact that two indifference curves cannot intersect each other and can also be shown by the law of
transitivity. Take point A on IC2, and point B on IC1 vertically below A. Combination A & C will give the
consumer equal satisfaction because they lie on the same indifference curve IC 2.Likewise between
combinations B & C on ICI, the consumer is in different because they give him same level of satisfaction.
If combination A is equal to combination C in terms of satisfaction and combination B is equal to
combination C, it follows that combination A will be equivalent to B in terms of satisfactions. But look at
the figure will show that this is absurd since combination A contains more number of commodity than
combination B, while the amount of commodity is the same in both the combinations. Thus, the consumer
will definitely prefer A to B, i.e., A will give more satisfaction to the consumer than combination B. We
therefore conclude that indifference curves cannot cut each other.
A higher indifference curve represents higher level of satisfaction than the indifference curve at the lower
level.

The combinations which lie on a higher

Indifference curve will be preferred to the
combinations which lie on a lower indifference
curve This is because combination A contains
more of both the goods than combination B.
Hence, combination A on a higher indifference
curve will give him more satisfaction than
combination B on lower indifference curve.

3.5 CONSUMERS' EQUILIBRIUM

Price Line or Budget Line

In order to explain consumers’ equilibrium, there is also the need for introducing the price line into the
indifference curve diagram, which represents the prices of the goods and consumers' income.

29
 Suppose our consumer has got Br. 100/ to spend on X
and Y. Let the price of commodity X in the market be
Br, 20/per 8 unit and that of Y be Br. 10/. If he spends
the whole of his income on X, he would buy 5 units of
X and if the entire amount is spent on Y, he would buy
10 units of Y. These two therefore represent the two
extreme alternatives open to the consumer.

In other words, he can buy any combination that lies in the price line with his given income. Combination
outside the price line AB will be beyond the reach of the consumer with his given income and the price of
goods. and any point within the reach of the consumer. But on such combinations, he will not be spending
all his income. He will not be at point G inside AB since by assumption, he spends all his income on X or
Y. Therefore, the consumer with given income under given market conditions will have different
opportunities of consumption along path Ab. By superimposing the indifference curve on the price or
budget line, the equilibrium position of the consumer is determined. A consumer is said to be in
equilibrium when he is buying such a combination of goods, which leaves him with no tendency to
rearrange his purchases of goods.
Assumptions
The following assumptions are made to explain the consumers' equilibrium.

30
a) He has a given amount of money to spend on the two goods.
b) Prices of all the goods are fixed in the market so that no individual consumer can alter the price.
c) Goods are homogeneous and divisible.
d)The consumer is rational, i.e.; the consumer will maximize his satisfaction with given income and
prices of goods.

Conditions
The consumer is in equilibrium when he maximizes his utility, given his income and the market prices.
Two conditions must be fulfilled for the consumer to be in equilibrium.
The first condition is that the marginal rate of substitution be equal to the ratio of commodity prices.
MRS xy = Mux = Px
Muy Py
This is a necessary but not a sufficient condition for equilibrium. The second condition is the indifference
curves be convex to the origin.This condition is fulfilled by the axiom of diminishing MRS.

Graphical Presentation
Given the indifference map of the consumer and his budget line, the equilibrium is defined by the point of
tangency of the budget line with the highest possible indifference curve. At the point of tangency, the
slopes of the price line Px/Py and of the indifference curves (MRSxy = Mux/My) are equal.

Mux = Px
Muy Py
Thus, the first order condition is denoted graphically by
the point of tangency of the two relevant curves. The
second order condition is implied by' the convex shape of
the indifference curves. The consumer maximizes his
utility by buying OX and OY of the two commodities.
Any other possible combination of the two goods either
would lie on a lower indifference curve and thus yield
less satisfaction, or would be unattainable.

Take point E which also lies on the same price line AB, but E lies on lower indifference curve IC1 and
therefore will yields less satisfaction than P. Likewise, points F, G. H are also rejected in favor of p, since
they lie on lower indifference curve. It is thus clear that of all combinations lying on AB combination, P

31
lies on the highest possible indifference curve and yield maximum possible satisfaction and therefore the
consumer will be in the equilibrium position at point P.
Only at the tangency point of P, the slopes of the price line and indifference curve are equal. The slope of
the indifference curve, while the slope of the price shows the MRS xy line, indicates the ratio between the
prices of the two goods. At points EF, the marginal rate of substitution (MRSxy) is greater than the given
price ratio. Hence, he will buy more of X than Y and come down along the price line. He will continue to
do so till MRSxy = Px/Py. On the contrary, at points GH, MRSxy is less than the given price ratio.
Therefore, it will be to the advantage of the consumer to substitute good y for good x and thereby move
up the price line AB until the MRS xy =Px/Py. Therefore, only at point P, the consumer is in equilibrium
because at that point the price line is tangent to the indifference curve. In other words, the marginal rate of
substitution of good x for good y must be equal to the ratio between the prices of the two goods.

3.6 INCOME, SUBSTITUTION, AND PRICE EFFECTS

Another concept associated with indifference curves is the income effect. So far, we have assumed a
consumer with a given income buying two different commodities at given prices. We must also consider
how the consumer will react in regard to his purchases of the commodity when his commodity income
changes while prices of the goods and his tastes and preferences remain unchanged. Thus, the income
effect means the change in consumer's purchases of the goods as a result of change in his income. The
income effect is illustrated using figure 3.10.

32
With given price and money incomes as indicated by price line P 1L1 ,the consumer is in equilibrium at
point Q (see fig. 3.10). If the income of the consumer increases, with increased income, he would be able
to purchase larger quantities of both the goods. As a result of a change in his income, the price line will
shift upwards to the right and will be parallel to the price line P 2L2. With further rise in income, the price
line shifts to P3L3 and the consumer is at equilibrium at S. If the various points of Q, R & S showing
consumer's equilibrium at various levels of income are connected, we will get the income consumption
curve. Income consumption curve is thus the locus of equilibrium points at various levels of consumer's
incomes.

If the income effect is positive for both the

goods X and Y, the consumption curve will
slope upwards to the right as given below by
ICCI in fig. 3.11. If the income effect is
negative for good X, ICC will slope backward
to the left as ICC2. It will slope CC3
downwards to the right as ICC3 if commodity
Y happens to be an inferior one.

Substitution Effect
Yet another factor responsible for the changes in the consumption of commodity is the substitution effect.
Under this effect, we assume change in prices for a corresponding change in money income with the
result that the consumer is neither better off nor worse off than before, i.e., the real income of the
consumer remains the same. However, when prices change, commodities which are cheaper, would be
substituted for commodities, which are dearer. This result is known as substitution effect.
Diagrammatically substitution effect is illustrated below:

33
With the given income and prices, the consumer is at equilibrium at point Q on the indifference curve,
purchasing ON of commodity of Y and OM of commodity X. Suppose the price of commodity X falls,
the price line shift to PLl. With this fall in price the consumer's real income or purchasing power would
increase. In order to find out the substitution effect, the gain in real income should be wiped out by
reducing money income of the consumer that forces him to stay on the same indifference curve. When
some money income is taken away, the price line is shifted to a new position PL1 parallel to AB This
means that the reduction of consumer's income by the amount PA (in terms of Y) or LIB (in terms of X)
has been made to keep him on the same indifference curve. The consumer would therefore rearrange his
purchases of X and Y and will substitute X for Y since X is now relatively cheaper and Y is now relatively
dearer. Thus, in order to buy more of X, he moves on the same indifference curve from point Q to point T.
Thus, increase in the purchase of commodity x by MM1 and the decrease in the purchase of commodity Y
by NN1 is due to the change only in the relative prices of commodity x and y, This is because the effect
due to the gain in real income has been wiped out by making a simultaneous reduction in consumer's
income. Therefore movement form Q to T represents the substitution effect. Substitution effect on
commodity X, is the increase in its quantity purchased by MM 1 and substitution effect on Y is the fall in
the quantity purchased by NN1. In short, the substitution effect implies that a change on the real income of
a consumer due to a change in the price is compensated by a corresponding change in money income but
the relatively cheaper commodity is bought in the place of the dearer one.

Price Effect

34
 This effect shows the reaction of the consumer
and measures the full effect of the change in the
price of the commodity on the quantity
purchased with given money income.
To begin with, the consumer is at equilibrium at
point Q on budget line AB. With the fall in the
price of X, the budget line shifts to the right
BA1and the consumer can now buy OAI of X of
OB of Y. A further fall in price of X will shift
the budget line to BA2 and so on.

By joining Q, Ql and Q2 we got a curve called the price consumption curve. The price consumption curve
shows the price effect.

3.7 DERIVATION OF DEMAND CURVE FROM INDIFFERENCE CURVE

The demand curve can be derived from indifference curves. This is done by measuring money on Y -axis
and units of X commodity on X -axis. As the price of commodity X falls, the consumer will be moving to
a higher indifference curve. With the help of unit' price of X, the demand curve for commodity X can be
drawn, where it will be downward sloping. This indicates that more and more of X will be bought as price
of X falls.

35
 3.7.1 Graphic Presentation

Money is measured along Y-axis and commodity X along X-axis. To begin with, the consumer is at
equilibrium position at A, where the price line RA2 is tangential to indifference curve IC 1. If there is a fall
in the price, the price line shifts to RB 2 and the consumer has a new equilibrium position at B. With every
fall in the price of X, the consumer moves from one position of equilibrium.

3.8 SUMMARY

Indifference curve analysis is based on an ordinal measurement of utility. By consuming a combination of

commodities, a consumer can compare the different utilities. Indifference curve is the line of those
combinations of two commodities, Say X and Y goods, which yield equal satisfaction to the consumer. A
consumer gets eq1illibrium when the ratio of marginal utilities from two commodities is equal to the ratio
of commodity price. It also happens when the indifference curves are convex to the origin. The ratio of
commodity prices is explained through price time.

3.9 ANSWERS TO CHECK YOUR PAROGRESS EXERCISES

1. The ordinal utility emphasizes that the exact measurement of utility is not possible and at best a given
ranking to customers' satisfaction instead of measuring in units.

3.10 MODEL EXAMINATION QUESTIONS

36
1. What are indifference curves?
2. Can two indifference curves intersect each other?
3. What is price line?
4. Explain the concepts income and substitution effects? "
5. Why do indifference curves slope downward?
6. Explain the properties of indifference curves.

3.11 REFERENCES

 Varian. R Hall (1999) intermediate microeconomics.

 Koutseyianniss A (1985) Modern microeconomics. :
 Gonld and Furguson (1985) microeconomic theory.
 Jhingan, M.L (1998) microeconomic theory.
 Barthwal. R.R (1992) microeconomic

37
Unit 4: Theory of Demand

Contents
4.0 Aims and Objectives
4.1 Introduction
4.2 Meaning
4.3 Types of Demand
4.4 Demand schedule and curve
4.5 Factors determining demand
4.6 Law of demand
4.7 Summary
4.8 Answers to check your progress
4.9 Model Examination Questions
4.10 Reference

4.0 AIMS AND OBJECTIVES

This unit deals with the meaning of demand, types of demand and, law of demand and exceptions.
By the end of the unit, you will be able to:
 understand the meaning of demand;
 list the types of demand;
 explain the law of demand;
 enumerate the exceptions to law of demand.

4.1 INTRODUCTION

This unit attempts to determine the various factors which affect demand. It is not only the law of
demand that affects demand; since it is misleading that it concentrates on price as the sale determinant
of demand. However, demand has multivariate relationship as it is derived by many factors
simultaneously. Some of the important determinants of the market demand for a particular product or
the price of the product itself are consumer's income, prices of other commodities in the market,
consumer's tastes, income distribution, total population, consumers wealth, credit availability,
government policy, past levels of demand, and past levels of income. But the traditional theory of
demand has discussed only four of the above determinants -the price of the commodity, the price of
other commodities, incomes, and tastes.
38
 4.2 MEANING

In our day-to-day life, we use the word 'demand' in a loose sense to mean the desire of a person to
purchase a commodity or service. But in economics it has a specific meaning. Demand implies more
than a mere desire to purchase a commodity. It states that the consumer must be willing and able to
purchase the commodity, which he desires. His desire should be backed by his purchasing power. A
poor person is willing to buy a car; it has no significance, since he has no ability to pay for it. On the
other hand, his desire to buy the car must be backed by the purchasing power constituting demand.
Demand, thus, means the desire of the consumer for a commodity backed by purchasing power. These
two factors are essential. If a consumer is willing to buy but is not able to pay, his desire will not
become demand. Similarly, if the consumer has the ability to pay but is not willing to pay, his desire
will not be called demand.

Exercise –1
1. What is a demand?

________________________

4.3 TYPES OF DEMAND

There are three types of demand

a) Price demand,
b) Income demand, and
c) Cross demand
Price demand: -This refers to various quantities of a commodity or service that a consumer would
purchase at a given time in a market at various hypothetical prices. It is assumed that other things such as
consumer's income, tastes and prices of interrelated goods remain unchanged. The quantity demand of a
particular commodity depends on the price of that commodity.
(Dx = f(Px)
Where Dx stands for commodity X
f denotes function
P x for price
The functional relationship between price and quantity demanded is well accepted. Consumer behavior is
so consistent that economists feal justified in making the strongest possible generalizations concerning the

39
relationship between price and demand. The relationship between price and demand is called inverse
relationship. This relationship is generalized by downward sloping demand curve

Y d

Price
d
Demand X

The functional relationship between quantity demand and price is illustrated with the help of demand
curve. In the above diagram, the price is on the vertical axis and the quantity demanded is on the
horizontal axis. The curve dd is labeled as demand curve.

Income Demand
This refers to the various quantities of goods and services, which would be purchased by the consumer at
various levels of income. There is critical functional relationship between income changes and changes in
consumption quantity. This functional relationship is defined as
Dx = f(y)
It means, the quantity of good X purchased is a function of consumer's income. The functional
relationship between income and quantity demanded may be inverse or direct. There is no great
consistency of response by consumers with respect to quantity variation for different goods as incomes
change. Consequently, it is difficult to make strong generalizations with respect to this functional
relationship. In the case of superior or normal goods, the demand will increase with the increase in
incomes.
‘OX’ axis represents demand for superior or normal goods,
while 'OY' axis represents income. When the consumer's
income is on ON, his demand is 'OM'. But when his income
increases from ON to ON1, the demand increases from 'OM'
to OM1Against this, demand for inferior commodity
decreases with the increase in income. This relationship is
0 called inverse relationship.

The above diagram tells us that on 'ON' income, the

demand for the commodity is 'OM'. But the consumer's
income increases from ON to ON1, the demand of the
commodity decreases from OM to OM1. 0

40
Cross Demand
Cross demand means the various quantities of commodities or services, which will be purchased with
reference to changes not of this commodity but of other interrelated commodities. These goods are either
substitutes or complementary goods. The correlation between the demand for one commodity and the
price of another may be positive or negative according to the manner in which these two commodities are
related to each other.
If the two
commodities are
substitutes, then
obviously they
satisfy the same
want. The more
the consumer buys
of one, the less he
requires of the
other. For
example, tea, and coffee are good substitutes. If the price of tea increases, the consumer may buy less of it
as they can buy more of coffee. Thus, a rise in the price of tea increases demand for coffee. A fall in the
price of tea, on the other hand, may reduce the demand for coffee because the consumers will now
increase their intake of tea.

4.4 DEMAND SCHEDULE AND CURVE

Demand Schedule:
A demand schedule can be constructed to any commodity if the list of prices and quantities purchased at
those prices are known. An individual demand schedule is a list of the various quantities of a commodity,

0 41
which an individual consumer purchases at various levels of prices in the market. A demand schedule
states the relationship between two variables of price and quantity demanded.

Imaginary demand schedule for oranges

Price per dozen Quantity demanded
Birrs In Kgs.
1 15
2 12
3 10
4 7
5 5

In the above diagram, prices of oranges are given on 'OY' axis and demand on 'OX' axis. When the price
per Kilogram is Birr 1 only, 15 kilograms are demanded. If we plot the data as above, you may notice that
if the price falls down, demand increases and vice- Versa.

dd

4.5 FACTORS DETERMINING DEMAND

The following factors may determine demand

I. Changes in fashion
II. Changes in weather
III. Changes in quantity of money in circulation
IV. Changes in population
V. Changes in wealth distribution
VI. Changes in technology
VII. Advertisement

4.6 LAW OF DEMAND

42
Law of demand emphasizes the functional relationship between the price of a commodity and its quantity
demanded in the market. It means that it shows us an inverse relationship between the above two
variables. "The greater the amount to be sold, the smaller must be the price at which it is offered in order
that it may find purchasers; or in other words, the amount demanded increases with a fall in the price and
diminishes with a rise in price". But the above law operates only under the assumption that “other things
remaining constant". The above phrase implies that when we state the law of demand, we assume
1) The income of consumer will not change.
2) The tastes and fashions remain same
3) The price of other related commodities remain unchanged.
Exceptions
Giffen's Paradox
As per the law of demand, if the price increases, the demand should decrease. But, sometime it may rise.
In other words, sometimes people may buy more when the prices are high. This was invented by Sir
Robert Giffen.
Prestigious goods
Sometimes people purchase certain goods as their possession confers a higher social status on them. For
example, diamonds and precious stones are purchased by rich people to maintain high prestige in the
society without caring for the high price of goods.
Speculation
Sometimes, the price of a commodity might increase and it is expected to increase still further. The
consumers will buy more of the commodity at higher prices than they did at lower price. The increase in
price may not be accompanied by a decrease in its demand, which is contrary to the law of demand.

Exercise -2
1. Explain the law of demand and associated exceptions.
___________________________________________________________________________________
___________________________________________________________________________________
___________________________________________________________________________________

4.7 SUMMARY

Demand for a commodity depends on the willingness of a consumer and his purchasing power. There are
three kinds of demand price, income, and cross demand.
Law of demand states that when the price increases, demand decreases and vice- versa. This law has
certain exceptions viz. Giffen’s paradox, prestigious goods, and speculation.
43
4.8 ANSWERS TO CHECK YOUR PROGRESS EXERCISE

1. The term demand denotes two things: the willingness of a consumer to buy and purchasing power or
by capacity to buy; otherwise it doesn’t mean that there is a demand.
2. The law of demand states that when the price of a commodity decreases, then the demand increases and
vice-versa but there are exceptions relating to prestigious goods and speculation (see the Giffen’s
paradox)

4.9 MODEL EXAMINATION QUESTIONS

1. What does demand mean?

2. What are the factors that affect demand?
3, Explain the law of demand, viz. Giffen's paradox?

4.10 REFERENCES

 Varian, R Hall (1999) Intermediate microeconomics.

 Koutseyianniss A (1985) Modem microeconomics,
 Gonld and Furguson (1985) microeconomic theory.
 Thingan, M.L (1998) microeconomic theory.
 Barthwal, R.R (1992) microeconomic theory.

44
UNIT 5: ELASTICITY OF DEMAND

Contents
5.0 Aims and Objectives
5.1 Introduction
5.2 Meaning of Elasticity of Demand
5.3 Price Elasticity of Demand
5.4 Income Elasticity of Demand
5.5 Cross Elasticity of Demand
5.6 Measurement of Elasticity
5 .7 Summary
5.8 Answers to Check Your Progress Exercises
5.9 Model Examination Questions
5.10 References

5.0 AIMS AND OBJECTIVES

This unit deals with the meaning, types, and measurement of elasticity of demand. Therefore, upon
completion this of unit, you will be able to
 define the elasticity of demand
 explain the price, income, and cross elasticties of demand
 explain measurement of the elasticity of demand.

5.1 INTRODUCTION

In microeconomics, elasticity is used as a method to measure the degree of dependant variable’s

responsiveness to changes in an independent variable. Elasticity has various applications most of which
are interesting and useful in the study of consumption demand.

5.2 MEANING OF ELASTICITY OF DEMAND

Elasticity means the degree of responsiveness of quantity demanded to the change in price. It is a
measurement of the percentage of responsiveness of a dependent variable to a percentage change in an
independent variable.

45
KINDS OF ELASTICITY OF DEMAND
There are many determinants for elasticity of demand. The most important determinants of elasticity are:
1. Price elasticity of demand
2. Income elasticity of demand
3. Cross elasticity of demand

5.3 PRICE ELASTICITY OF DEMAND

It is a measure of the responsiveness of demand to changes in the commodity's own price. It can also be
expressed as the ratio of a relative change in quantity to a relative change in price. The formula for
calculating the price elasticity of demand is:
Ep = Percentage change in the quantity demanded of X
Percentage change in the price of X
Ep= DX ÷ PX
DX PX
Where Ep=price elasticity

If the percentages are known quantities, quantities the numerical size of E can be easily calculated. Let us
suppose that the percentage increase in the quantity is 3 and the percentage fall in the price is
1. then
Ep = 3% = -3
-1%
It is usually understood that even through price elasticity is always negative, we usually put price
elasticity in positive sign. Therefore instead of -3 Ep will be =3

KINDS OF PRICE ELASTICITY OF DEMAND

Price elasticity of demand is generally classified into five categories. These are
i) PERFECTLY ELASTIC DEMAND

It is a situation where the slightest rise in price causes

EP = α
the quantity demanded of the commodity to fall to zero.
D D
Similarly, the slightest fall in price causes an infinite
Price
increase in the quantity demanded of the commodity.
This type of case is exceedingly rare in real life. It can
O Demand
be shown with the help of a diagram. (see fig 5.1) Here,
Fig 5.1 the demand curve is a horizontal straight line.

46
ii) PERFECYLY INELASTIC DEMAND

D
D EP = 0
Price

O D X
Demand
Fig 5.2
In this case, even substantial changes in the price will not bring about any change in demand. The demand
insensitive or not responsive to changes in price. The elasticity of demand is therefore zero. Like perfectly
elastic demand, cases of perfectly inelastic demand are also rare in real life. It can be shown with the help
of a diagram (see diagram 5.2.) In this case, the demand curve is a vertical straight line.

iii) RELATIVELY ELASTIC DEMAND

It is a situation where a small proportionate

change in the price of a commodity is
accompanied by larger proportionate change in
its quantity demanded. Elasticity of demand
here is said to be greater than unity. Look at
diagram 5.3

IV) RELATIVELY INELASTIC DEMAND

47
 This a situation where a substantial change
in the price of commodity is accompanied
by a smaller proportionate change in its
quantity demanded. Elasticity of demand
here is said to be less that unity. diagram
5.4 Refer the fig 5.4 here

v) UNITARY ELASTIC DEMAND

This refers to a situation where a given

proportionate change in price is
accompanied by an equally proportionate
change in the quantity demanded.
Elasticity of demand here is said to be
equal to unity. This is shown diagram
5.5.

Table 5.1 PRICE ELASTICITY-MEASURES, MEANING AND NUMENCAL MEASURE

Numerical measure of
Description Terminology
Elasticity
Quantity demanded does
Zero Perfectly
not change as price changes
Greater than Quantity demanded changes
Zero but less By a smaller percentage Inelastic
Than one Than does price
Quantity demanded changes
One by exactly the same percentage Unit elasticity
as does price

48
 Greater than Quantity demanded changes
one but less By a larger percentage Elastic
than infinity Than does price

Purchasers are prepared to buy all they can

Perfectly
Infinity obtain at some price and none at all at an
elastic
even slightly higher price
Source: Richard G. Lipsey, An Introduction to Position Economics, ELBS, 1974, p.lO2

Basic determinants of price elasticity of demand

According to Koutsoyiannis, the basic determinants of the elasticity of demand of a commodity with
respect to its own price are
1. The availability of substitutes: the demand for a commodity is more elastic if there are close substitutes
for it.
2. The nature of the need that the commodity satisfies: in general, luxury goods are price elastic, while
necessities are price inelastic.
3. The time period: demand is more elastic in the long run.
4. The number of uses to which a commodity can be put: the more the possible uses of commodity, the
greater its price elasticity will be.
5. The proportion of income spent on the particular commodity.

Exercise –1
1. What is price elasticity of demand?
___________________________________________________________________________________
___________________________________________________________________________________
___________________________________________________________________________________

5.4 INCOME ELASTICITY OF DEMAND

The responsiveness of demand to changes in income is termed as income elasticity of demand. It can also
be expressed as the proportionate change in the quantity demanded resulting from proportionate change in
income.
Ey = Percentage change in quantity demanded
Percentage change in income
Symbolically, it can be represented as :
Ey = ▲ D ÷ ▲Y

49
 D Y
For normal goods, income elasticity is positive. Some writers have used income elasticity in order to
classify goods into ‘luxuries’ and “necessities". A commodity is considered to be a luxury if its income
elasticity is greater than unity. A commodity is necessity if its income elasticity is small.
The main determinants of income elasticity are
1. The nature of the need that the commodity covers: the percentage of income spent on food declines as
income increases (this is known as Engel's Law)
2. The initial level of income of a country: for example, a T. V set is a luxury in an underdeveloped
country, while it become a 'necessity' in a developed country.
3. The time period: because consumption patterns adjust with a time-lag to changes income.

5.5 THE CROSS ELASTICITY OF DEMAND

It is the responsiveness of demand to change in the price of other commodities. It can also be defined as
the proportionate change in the quantity demanded of X resulting from a proportionate change in the price
of Y.
Exy = percentage change in the quantity demanded of X
Percentage change in the price of commodity y
Cross elasticity may vary from minus infinity to plus infinity. Complementary goods will have negative
cross elasticity.Substitute good’s on the other hand,will have positive cross elasticities.
The main determinant of the cross elasticity is the nature of the commodities relative to their uses. If two
commodities can satisfy equally well the same need, the cross elasticity is high and vice-versa.

5.6 MEASUREMENT OF ELASTICITY

There are three methods for measuring elasticity of demand .These re

i) Total Outlay or Expenditure method
ii) Point method, and
ii) Arc method

TOTAL OUTLAY OR EXPENDITURE METHOD

This method is associated with the name of Alfred Marshall according to which we measure the elasticity
by examining the change in the total expenditure due to a change in price. We can observe this in the
following demand schedule.

50
 Table 5.2: Demand Schedule for Tooth Brushes
Price per Number Toot al amount
Tooth Brush demanded spent
Br.2.00 2 Br.4.00….(1)
Br.1.00 3 Br.3.00….(2)
Br.0.75 4 Br.3.00….(3)
Br.0.62 5 Br.3.10…..(4)

In the above schedule, the total amount of money spent decreases with a fall in the price(increases with a
rise in price) from Br 2=00 to Br 1=00 the total amount spent decreases from Birr 4=00 to Br.3=OO. In
this case, the elasticity is said to be less than unity. In between (2) and (3), the total amount of money
spent remains the same. It means that when the price decrease from Birr. 1=00 to Br, 0=75, the total
expenditure remains at Br.3=OO. In this case, the elasticity is said to be equal to unity. In between (3) and
(4), the total amount of money spent increases with a fall in price (or deceases with a rise in price).The
elasticity is said to be greater than unity. The total amount spent increase from Br.3=00 to Br3=10. This
method can also be represented with the help of a diagram

In Fig 5.6, total expenditure is Y measured along

OX axis and price along the OY axis. We get a
backward sloping curve “OLUM". The portion OL'
represents less than unitary elasticity, because an
increase in price decreases the total expenditure. The
"LU' portion represents unitary elasticity because a
change has no effect on the total expenditure, as it
remains constant. The portion ‘UM' represents
elasticity more than unity, because an increase in
price decreases the total expenditure and a decrease
in price increases the total expenditure.

THE POINT METHOD

This method is also suggested by Alfred Marshall. In this method, we take a straight-line demand curve
joining the two axis, and measure the elasticity between two points Q and Q 1 which are assumed to be
intimately close to each other.

51
In Fig 5. 7, ‘RP' is the straight-line demand curve,
which connects both the axes. In the beginning, at
the price QM, the quantity demanded is OM. Then
the price changes to QIMI and the new quantity
demanded is OM1. The symbol ‘P’ represents the
change in price, while the symbol ‘Q' shows the
change in quantity demanded. The price elasticity of
demand can be determined by the following formula.

52
Ed = Percentage change in quantity demanded
percentage change in price
The percentage change in quantity demanded can be found out using:
change in quantity demanded = D
Initial quantity demanded D

The percentage change in price can be found out thus:

=Change in price = P
Initial price P
Change in quantity
Ed= initial quantity= D ÷ P
Change in price D P
Initial price

On a straight-line demand curve, we can make use of this formula to find out the price elasticity at any
particular point. We can find out numerical elasticity also on different points of the demand curve with
the help of the above formula. It should be remembered that the point elasticity of demand on a straight
line is different at every point. Elasticity at anyone point is the ratio of the lower part of the straight line
demand curve. It is called point elasticity of demand.

ARC METHOD
The main drawback of the point method is that it is applicable only when we possess information about
even the slight changes in the price and the quantity demanded of the commodity. But in practice, we do
not possess such information about minute changes.
We may possess demand schedules in which there are big gaps in price as well as the quantity demanded.
In such cases. Therefore there is an alternative method known as arc method of elasticity measurement. In
this method, the midpoints between the old and the data in the case of both price and quantity demanded
are used. It studies a portion or segment of the demand curve between the two points. An arc is a portion
of a curve line, hence, a portion or segment of a demand curve, The formula for measuring arc elasticity
is given below.
Ed = Change in quantity demanded ÷ Change in price
Original quantity plus new Original price plus
quantity demand new price after change

Symbolically, the formula may be expressed thus:

Ed = Q-Q1 ÷ P-P1
Q+Q1 P+P1

53
Here, Q = Original Quantity demanded
Ql = New quantity after change in price
P = New price after change
P 1 = New price after change
We can take a numerical example to illustrate arc elasticity. Suppose that the price of a commodity is Br 5
and the quantity demanded at that price is 100 units of a commodity. Now assume that the price of the
commodity falls to Birr, 4/- and the quantity demanded rises to 110 units, using the above formula, arc
elasticity, will be
Ed= 100-100 ÷ 5-4
100+100 5+4

= -10 ÷ 1
210 9

= -9
21

=3
7

5.7 SUMMARY

This unit bas discussed the meaning of elasticity and three kinds of demands. The price elasticity of
demand explains the responsiveness of demand due to changes in price. The relationship between relative
change in demand and proportionate change in income is explained by income elasticity of demand.
Cross elasticity measures the responsiveness of demand for a commodity due to changes in the price of
other related commodity.

5.8 ANSWERS TO CHECK YOU PROGRESS ECERXISE

1. Price elasticity is the responsiveness demand to changes in the commodity's own price. It is the ratio of
a relative change in price and its impact on demand.
Ep == % Change in the quantity demand
% Change in price

54
5.9 MODEL EXAMINATION QUESTIONS

1. What do we mean by elasticity of demand?

2. Explain the types of elasticity of demand
3. What is price elasticity of demand?
4. Explain cross elasticity of demand
5. What are the determinants of price elasticity of demand?

5.10 REFERENCES

 Varian. R Hall (1999) Intermediate microeconomics.

 Koutseyianniss,A (1985) Modern microeconomics.
 Gonld and Furguson (1985) microeconomic theory.
 Jhingan, M.L (1998) microeconomic theory.
 Barthwal, R.R (1992) microeconomic theory.

55
UNIT 6. PRODUCTION FUNCTION

Contents
6.0 Aims and Objectives
6.1 Introduction
6.2 The Concept of Production Function
6.3 Production Function for a Single Product
6.4 The Law of Variable Proportion
6.5 Summary
6.6 Answers to Check Your Progress
6.7 Model Examination Questions
6.8 References

6.0 AIMS AND OBJECTIVES

This unit aims at discussing the meaning of production, production function, and the law variable
proportions, At the end of the unit, you will be able to:
 understand the meaning of production
 explain the production functions
 understand the law of variable proportions.

6.1 INTRODUCTION

The term production refers to the creation of those goods and services which have change value. It is
concerned with the creation of economic utilities. The economic utilities are of three forms:
I. Form utility,
II. Time utility, and
Ill. Place Utility.
Production is an activity whether physical or mental which is directed to the satisfaction of other people's
wants through exchange.
Essentials of production
I. No production is possible without some activity, whether it is physical or mental.
II. The activity must be directed to the satisfaction of other people's want. Thus, if a farmer produces
wheat for self consumption, this activity will not be regarded as one of production

56
 III. Other people's wants must be satisfied through the process of exchange. If a teacher teaches
students without any remuneration in exchange, his service cannot be treated as production.

In general sense, economists have characterized the production process as a combination of four factors
of production: land, labor, capital and organization. Land plays an important role in agriculture sector,
while other factors have prominence in industrial sector. The entrepreneur who looks after the
organizational aspects of production is the decision maker who through the combination of the factors
produces the output. Entrepreneurship is an important trait for the development of any country's economy.
The entrepreneur is often considered as an innovatory while the four factors are considered important for
the production process.

Exercise -1
1. What do you mean by production?
_____________________________________________________________________________
_____________________________________________________________________________
2. What are the factors of production?
_____________________________________________________________________________
_____________________________________________________________________________

6.2 CONCEPT OF PRODUCTION FUNCTION

The production function is purely technical relation, which connects factor inputs and outputs. Production
function for any commodity that may be produced per unit of time for each set of alternative inputs, when
the best of production techniques are used. It describes the laws of proportion, that is the transformation
of factor inputs into outputs during any particular time period. The production functions are present either
in technology of a firm or industry or of the economy as a whole. It shows how, and to what extent output
changes with variations in inputs during a specified period of time. Production function expresses the
functional relationship between quantities of inputs and outputs this can also be expressed in
mathematical equation form in which output is the dependent variable and inputs are the independent
variables.
P = f(ABCD)
P = output of goods
ABCD = inputs used in producing outputs
The production function is always specified for a period of time. It is the flow of inputs resulting in a flow
of output during a specified period. Every manufacturing firm has its own production function, which is
determined by the state of the technical knowledge, and managerial ability of that firm. Improvement of
57
technical knowledge or managerial ability of the firm will bring about a new production function in the
place of the existing one. The new production function either gives more output with the same quantity of
original inputs or it may use smaller quantity of inputs for the same original outputs.

Assumptions
a) It is always related to a specified period of time.
b) Technical knowledge is assumed to be constant.
c) The firm in question will use the best and the most efficient technique available.
d) The factors of production are divisible into variable units.

6.3 PRODUCTION FUNCTION FOR A SINGLE UNIT

For producing one commodity, several methods of production may be available. A method of production
is the combination of factor inputs required for the production of one unit of output. For example, a unit
of commodity 'X' may be produced by the following processes.

Process P1 P2 P3
Capital Unit 2 3 1
Labor Units 3 2 4

The three activities described above may be graphically presented by length of lines from the origin to the
point determined by the labor and capital units.

If there are two methods A and B to produce commodity 'X'; method A is considered technically efficient
in relation to other method B, if ' A' uses at least one factor less than B. For example, the two methods A
and B require the following factor inputs.

58
 A B
Labor 2 3
Capital 3 3

In the above example, method' A' is technically efficient when compared to method 'B'. The theory of
production concentrates only on efficient methods of production. A rational entrepreneur always goes for
efficient methods of production. We must note that technically efficient method is not necessarily
economically efficient as there is a difference between technical and economic efficiency. For example,
the following two methods are technically efficient and are included in the production function.
A B
Labor 2 1
Capital 3 4

In the two technically efficient methods described above, one of them will be chosen at any particular
time depending on the price of factors of productions. The choice of technique is an economic one, which
is based on prices and not on its technical efficiency. The goal of the firm using a particular production
function is profit maximization that is maximization of difference.
II=R-C
II = Profit
R = Revenue
C = Cost
Production function as determined technical conditions of production is of two types.
I. Production function with one variable input is a short-term production function.
II. Production function with all variable inputs is a long-term production function.
In the short-run, it is possible to increase the quantities of one input while keeping the quantities of
other inputs constant in order to have more output. This aspect of production function is known as the
law of variable production. In the long run, it is possible for a firm to change all its inputs in order to
expand its business. This is known as "returns to scale”.

6.4 LAW OF VARIABLE PROPORTIONS

The law is also called production function with one variable input. According to this law, in the
production function of a firm, all the inputs are fixed except one. This one input is called the variable
input. For example, let us assume that all the inputs such as, machinery etc. of a firm are fixed, but labor
is made variable factor of production. Here, the firm tries to increase its output by increasing the supply
59
of labor (Other inputs being fixed). When the firm increases the supply of labor, it changes the
proportions between fixed and variable inputs. This law is concerned with the way in which the in put
changes when the number of units of variable input is increased keeping other inputs constant. When
more and more units of a variable factor are used, holding the quantities of fixed factors constant, a point
is reached beyond which the marginal product then the average product and finally total product will
diminish. This can be illustrated with the help of a table taking a 5-hectare plot of land.

Output of Teff (in units) from five hectares of land

No. of Total Average Marginal Stages
Laborers Product Product Product
1 8 8 8
2 20 10 12 Stage I
3 36 12 16
4 48 12 12
5 55 11 7 Stage II
6 60 10 5
7 60 8.6 0 Stage
8 56 7 4 III

In the above table, production function is revealed in the first two columns. The average product and
marginal product columns are derived from the total product column and number of labors column. Total
product is the total amount produced during a particular period by all the factors of production employed
over that period of time. If all the inputs except one are held constant, the total product will vary
according to the quantity of the variable factor used.
Average product (AP) = TP
L
AP = Average product
TP = Total product
L = Laborers
Marginal product (MP) = TP
L
An analysis of the above table shows that the total, average, and marginal products first increase till they
reach the maximum and then start declining. The total product reaches its maximum when 7 units of
laborers are used and then it declines. The average product continues to rise till the 4 th unit, while the
marginal product reaches its maximum at the 3rd unit of labor. Then it falls. It should be noted that the
point of falling output is not the same for total, average, and marginal products. The marginal product
60
follows it and the total product is the last to fall. This means that the tendency of diminishing returns is
ultimately found in the three productivity concepts.
From the above diagram, the total product (TP) curve first rises at an increasing rate, but later it moves
gradually towards the highest point, after reaching that point it starts to fall falling slowly. This can be
noticed by observing the slope of the TP curve. In the above chart at point 'a' the slope of TP is the
highest, at "b' it is less than 'a' and at "c' it becomes zero. The marginal product curve (MP) and the
average product (AP) curve also rise with TP.
K

The MP curve reaches its maximum point at 'd' when the slope of the TP curve is at the maximum point at
'a' and then it starts falling. The maximum point on the "AP' curve is where it coincides with the "MP'
curve. This point coincides at point 'e' with 'b' on the TP curve from where the total product starts gradual

61
rise. When the TP curve reaches is maximum point at 'c', the MP curve becomes zero at point 'f' and when
the former starts declining, the latter becomes negative. When the total products become zero, then rising
the average product becomes zero. The rising, the falling, and the negative phases of the total marginal
and average products are in fact the different stages of the law of variable proportions.

In stage -1, the total product increases at an increasing rate: one laborer produces 8 units, while two
laborers produce 20 units. In the first stage, the marginal as well as average products both rose, but the
marginal product raises faster than the average product because the marginal product is greater than the
average product, the former pulls up the latter. When the marginal product begins to decline, it still
exceeds the average product and tends to pull up the latter. When both marginal and average products are
equal, the marginal product neither pulls up nor pulls down the average product.

In stage II, the total product continues to increase no doubt but at a diminishing rate, till it reaches the
maximum point at "C'. The boundary for the second stage is at the point 'c' where the total product is
maximum and marginal product is zero. In stage II, the marginal product and the average product both
decline but the marginal product declines at faster rate than the average product .The marginal product
being lower than the average product pulls the average product down.

Stage III begins when the MP curve meets the X -axis and the TP curve reaches its maximum point. In
this stage any increase in the number of laborers on the farm causes a total product to decline. The
marginal product now becomes negative and the average product continues to decline though it remains
positive. As the marginal product becomes negative in this stage, no firm would choose to operate in it.

A rational entrepreneur is expected to maximize his profits since profit maximization is his goal, as long
as he produces in stage –I. He is irrational as he can still increase the Factor of production under
considerations and make more profits. Hence, stage –I is a zone of irrationality. The elasticity of
productions, which is defined as the ratio of marginal product to average product, is greater than one in
this zone. Stage -II is a zone of rationality as the entrepreneur can maximize his profits. The elasticity of
production will be between one and zero. In this stage, the marginal product curve touches the x-axis and
the value of marginal product becomes zero. As long as the elasticity of production becomes less than
zero, as it is shown in the diagram in stage -Ill, the entrepreneur, if he is rational, will not increase
production by increasing the variable factor beyond the point where its marginal product becomes zero. If
he chooses to increase the factor of production under consideration, he will not be maximizing his fits,
even though his output may be increasing at a decreasing rate.

62
6.5 SUMMARY

This unit has presented the meaning of production and its functions, which is the creation of utilities.
Production is the result of some sort of activity. It provides satisfaction and enables exchange. Production
function explains the technical relationship between inputs and outputs. It enables us to know different
methods to produce a commodity.

6.6 ANSWERS TO CHECK YOUR PROGRESS EXERCISES

1. Production is an activity of the creation of goods and services for the satisfaction of wants of others in
exchange of money. If one does any work for se1f-satisfaction, it cannot be treated as production
function.
2. There are four important factors of production viz. land, labor, capital and organization.

6.7 MODEL EXAMINATION QUESTIONS.

1. What is production?
2. What is production function?
3. Explain the law of variable properties

6.8 REFERENCES

 Varian. R Hall (1999) Intermediate microeconomics.

 Koutseyianniss A (1985) Modem microeconomics.
 Gonld and Furguson (1985) microeconomic theory.
 Jhingan. M.L (1998) microeconomic theory.
 Barthwal, R.R (1992) microeconomic theory.

63
UNIT 7: NEO-CLASSICAL PRODUCTON FUNCTION

Contents
7.0 Aims and Objectives
7.1 Introduction
7.2 Notion of Isoquant
7.3 Properties of Isoquants
7.4 The Marginal Rate of Technical Substitution
7.5 Isocosts
7.6 Producer's Equilibrium
7.7 Expansion Path
7.8 Summary
7.9 Answers to Check Your Progress Exercises
7.10 Model Examination Question
7.11 References

7.0 AIMS AND OBJECTIVES

The purpose of this unit is to briefly explain the theory of neo-classical production function with the help
of isoquants and isocosts.
Upon completion of this unit, you will be able to:

64
  define isoquants, isocosts expansion path etc.
 derive producer equilibrium.

7.1 INTRODUCTION

As we have seen earlier, the production function represents the range of technologically possible
alternative combinations of inputs and output, that an individual firm may realize. Based on the
theoretical formulation of the production function, empirical studies have been conducted and the concept
of production function acquired greater importance.
The production function usually involves, as independent variables, measures of labor and capital for a
single factory or firm. It may also involve, as independent variables, all other inputs, but the greater part
of the literature is concerned only with labor and capital as inputs.
As discussed in the previous unit, a combination of labor and capital as two inputs for providing output of
a certain commodity may involve different methods of production. The choice of any technique depends
on various economic factors though technical efficiency is another guiding factor. In this regard, the
concept of isoquant is important for understanding the process of production.

7.2 NOTION OF ISOQUANT

An isoquant is "the locus of all technical efficient methods. Of all the combinations of factors of
production for providing a given level of output". The production isoquant may assume various slopes
depending on the degree of substitution of factors.
Y

Capital Linear lsoquant assumes substitutability of factors of

A production. A given commodity may be produced by
using over capital or only labor or by infinite
combination of K and L. For example, a commodity
may require Br. 10,000 as capital for its production or
100 labors or combination of both where capital may
A
O X be substituted by labor or vice-versa .
Labor

Y A Input-output Isoquants-This assumes strict

complimentarty that is zero substitutability of the
Capital factors of production. There is only one method of
A production for any commodity. This type of isoquant
is 65called 'Leontie Isoquant' after Leontief who
invented the input-output analysis.
 O X
Labotr

Suppose, in order to produce a commodity, we have only one method, where we use capital alone. Or, to
produce commodity B we have only one method, where we use labor alone, if we encounter non-
substitutability of factors of production in either of the above cases.
Y P1 Kinked Isoquant -This assumes limited substitutability of K
P2 and L. There are only few processes for producing anyone
Capital P3 commodity. Substitutability of the factors is possible only at
the kinks. This form is also called activity analysis -isoquant
A
P4
A

O X
Labor
-Kinked isoquant -or linear programming isoquant,is so called because it is basically used in linear
programming. For example, in Teff cultivation, bullock labor can be replaced by tractor for ploughing
operations but for transplantation work, the substitutability between labor and capital is limited, as this
work has to be done by labor.

Capital

X
Labor

Smooth Convex Isoquant -In this type of isoquant, continuous substitutability of K and L only,
over a certain range, is assured, beyond which factors cannot be substituted each other.

For example,a tractor with few laborers or a number of ploughs with more laborers can
be used for seedbed preparation, where cultivation by the plough is a more labor -using
method of cultivation. Both the methods can yield the same output.

An isoquant shows the different combinations of labor and capital with which a firm can produce a
specific quantity of output. A higher isoquant refers to a greater quantity of output and a lower one to
smaller quantity.

66
 Isoquant-I Isoquant-II Isoquant-III
Labor capital Labour Capital Labour Capital
2 11 4 14 6 15
1 8 3 10 5 12
2 5 4 8 6 9
3 3 5 5 7 7
4 2.5 6 4 8 6
5 0.2 7 3.5 9 5
6 1.5 8 3.0 10 5
7 1.2 9 3.5 11 5.5

Plotting these points on the same set of axis and connecting them by smooth curves, we get three
isoquants as shown below.
The firm can produce the output specified by
isoquant-I by using 8K I and lL (point B) or by
using 5k and 2L (point C) on isoqua Isoquants as
mentioned above, specify cardinal measures 'of
output. For example, Isoquant-I might refer to 60
unit of physical output, isoquant- II 100 units of
output.

7.3 PROPERTIES OF ISOQUANTS

1. They have negative slope.

2. If one isoquant-II lies above and to the right of another isoquant-llI, then III will norma1y
correspond to a higher output level than -II
3. No two isoquants intersect each other.

The isoquants are convex to the origin. The rationale of each of these properties is closely analogous with
that involved in theory of the consumer, except for one feature that arises in isoquant. A consumer's as
indifference curve can be defined as a line of constant utility. But since the entire idea of utility
measurement is under suspicion, the utility level represented by each indifference curve cannot be
exactly specified with the help of numbers. In the case of isoquants, output level is a meaningful concept
and the curves can be labeled as 5, 10, 15, 20 etc.

In the case of convex isoquant, two factors of production, namely capital and labor, were shown on 'OY'
axis and 'OX' axis respectively and the production indifference curve shows here that whatever be the
combination of capital and labor, it yields isoquant curve is considered.

67
 Here the production is depicted in the form of a
set of isoquants. By construction, the higher to
the right an isoquant, the higher the level of
output it depicts, in this diagram of production
function, XI, X2, X3,

The efficient ranges of output have been depicted. The upper ridgeline implies that the marginal product
of capital is zero. The lower ridgeline implies that the marginal product of labor is zero. Production
techniques are only technically efficient inside the ridgelines. Outside the ridge lines the marginal
products of factors are negative and the methods of production are inefficient inside the ridgelines.
Outside the ridge lines the marginal products of factors are negative and the methods of production are
inefficient, since they require a greater quantity of both factors for producing a given level of output.
Inefficient methods of production are not considered by the theory of production as they imply irrational
behavior of the firm.

Exercise-1
1. What is an isoquant?
___________________________________________________________________________________
___________________________________________________________________________________
__________________________________________________________________________________
2. List the properties of isoquants?
___________________________________________________________________________________
___________________________________________________________________________________
___________________________________________________________________________________

7.4 MARGINAL RATE OF TECHNICAL SUBSTITUTION

The marginal rate of technical substitution or the marginal rate of substitution (MRS) refers to the amount
of K that a firm can give up by increasing the amount of L used by one unit and still remain on the same
isoquant. The MRS is equal to marginal product of labor divided by the marginal product of capital. As
the firm moves down on an isoquant, the MRS diminishes. For example, in the production function
diagram, if we are moving from point B to C on isoquant -1, the firm gives up 3 units of K for one
additional unit of L. Thus, the MRTS LK (marginal rate of substitution of L for K) = 3. Similarly if we

68
move from point C to point D on isoquant -1, the MRTS = 2, Thus, the MRTS LK diminishes as the firm
moves down on an isoquant. This is so because the less K and the more L the firm is using (i.e. the lower
the point on the isoquant), the more difficult it becomes for the firm to substitute L for K in production.

The factor intensity of any process is

measured by the slope of the line through the
origin representing the particular process. The
Factor Intensity is the capital-labor ratio.

In the above figure, process PI, is more capital intensive than process P2.
K1>K2
L2 L2

The upper part of the isoquant includes more capital-intensive process. The lower part of isoquant
includes more labor-intensive techniques.

7.5 ISOCOSTS

An isocost line shows "all different combinations of

labor and capital that a firm can purchase given total
outlay of the firm and factor prices." The slope of an
isocost is given by PLPk where PL refers to the price of
labor and Pk to the price of capital.

If the firm spent all of its outlay on capital, it could purchase total outlay/P k units of capital. If the firm
spent all of its total outlay on labor, it could purchase total outlay /P L units of labor. In this diagram,
capital is measured on 'OY' and labor on 'OX' axis. We get one point on 'OY' axis and another on OX
axis. Joining these two points by straight line, we get the isocost of the firm. The firm can purchase any

69
combination of labor and capital shown on its isocost line. For example, if Br. 1, 000 is the total outlay
and if a farmer decides to purchase ploughs only for Br. 100 he can purchase 10 ploughs. Similarly, if he
decides to spend Br. 1.000 for hiring labor, he may hire l00 laborers assuming the labor price is Br. 10.
But if he combines both capital and labor, he may have various combinations of labor and capital, which
are depicted on the isocost line, where the cost would be ) Br.1, 000 for any combinations on that line.

7.6 PRODUCER’S EQUILIBRIUM

A producer is in equilibrium when he maximizes output for his given total outlay. This means the
producer is in equilibrium when he reaches the highest isoquant, given the isocost. This occurs when an
isoquant is tangent to the isocost. At equilibrium, MRTS LK = PL/PK. Or, the marginal rate of substitution is
defined as the ratio of marginal product of labor to marginal product of capital. It must be equal to the
ratio of price of labor to price of capital.
This means that at equilibrium, the marginal product of the last Birr spent on labor is the marginal product
of the last Birr spent on capital. This is explained in the diagram below.

If the isoquants and isocost line are drawn with

reference to same 'axis, we can determine the
point of equilibrium. This is given by point N
in the above diagram. The firm cannot reach
isoquant-III with its isocost as shown above. If
the firm produced along isoquant-I, it would
not be maximizing output. Isoquant -II is the
highest that the firm can reach with isocost.

7.7 EXPANSION PATH

70
If the firm changes the total outlay, while the
prices of labor and capital remain constant, the
firm’s isocost shifts parallel to itself. It will move
up if total outlay is increased, and move down if
the total outlay is decreased. These different
isocosts will be tangent to different isocquants,
those defining different equilibrium points for the
producer. By joining the points of the producer
equilibrium, we get the firm’s expansion path.
This is analogous to income-consumption curve
discussed in indifference curve analysis.

Suppose the prices of the plough remain unchanged at Br. 100 and 10 Br. 10 respectively. But the total
outlay can be either Br. 800 or Br. 1, 000 or Br. 1, 200. The first isocost line is drawn for outlay of
Br.800.
The second is drownfor a total outlay of Br. 1,000 and third for Br. 1,200. The first isocost line is tangent
to the isoquant-I, at point m, the second isocost line is tangent isoquant-II at point N and the third isocost
line is tangento to isoquant III at point P. Joining the points OMNP, we get the expansion path of the firm.
The firm increases its output along this path under the assumption that prices of labor and capital remain
unchanged. In the above diagram the expansion path is straight line through the origin. This means when
the output is expanded the K/L ratio remains the same. In such a case, the ridgelines will also be straight
lines.

7.8 SUMMARY

In this unit production function has been discussed from neo-classical point of view. The notions of
isoquant and isocost are also explained.. By using these concepts and the concept of marginal rate of
technical substitution, producer's equilibrium is derived. In the last expansion path is shown. We have
also looked at expansions path.

7.9 ANSWERS TO CHECK YOUR PROGRESS EXERCISES

1. An isoquant is "the locus of all technical efficient methods, or all the combinations of factors of
production for providing a given level of output".

71
2. a) Their slope is negative
b) If one isoquant-II lies above and to the right of another, isoquant-ill will normally correspond to a
higher output level than-II
c) No two isoquants intersect each other.
d) The isoquants are convex to the origin.

7.10 MODEL EXAMINATION QUESTIONS

1. What do you mean by marginal rate of technical substitution?

2. Explain isocost with the help of diagram
3. What is expansion path?
4. What are isoquants?

7.11 REFERENCES

 Varlan. R Hall (1999) Intennediate microeconomics

 Koutseyianniss,A (1985) Modern microeconomics.
 Gonld and Furguson (1985) microeconomic theory.
 Jhingan, M.L (1998) microeconomic theory.
 Barthwal, R.R (1992) microeconoroic theory.

UNIT 8: LAWS OF RETURNS TO SCALE

Contents
8.0 Aims and Objectives
8.1 Introduction
8.2 Laws of Returns to Scale
8.3 Economics of Scale
8.4 Law of Supply
8.5 Elasticity of Supply
8.6 Summary
8.7 Answers to Check Your Progress Exercises
8.8 Model Examinations Questions

72
 8.9 References

8.0 AIMS AND OBJECTIVES

This unit presents the laws of returns to scale economies of scale, law of supply and elasticity of supply.
By the end of the unit, you will be able to:
 explain the laws of returns to scale
 list the economies of scale
 Understand the law of supply.

8.1 INTRODUCTION

In the previous unit you have learned about the production functions. This unit will introduce you to the
laws of returns to scale when the output is increased using various mix of factors of production in long
run. An attempt has been made to illustrate the law of supply and the elasticity of supply.

8.2 LAWS OF RETURNS TO SCALE

Expansion of output may be achieved by changing some inputs over, but in the long-run expansion of
output can be aliened by changing all factors of production. The laws of turns to scale’ refer to the effects
of scale relationship. Output can be increased in the long-run by changing all factors of production either
by the same proportion or by different proportions. The term returns to scale' refers to change in output as
all factors change by the same proportion. Returns to scale' are only one part of the economies of scale.
Returns to scale are technical economies of scale include the technical as well monetary economies. This
is the behavior of output in response to change in the scale production. An increase in the scale of
production implies that all inputs or factors are increased in the same proportion. Here, the factor
proportions do not change when the scale of production changes. The study of change in output as a result
of changes in the scale constitutes the subject matter of 'returns to scale'

Assumptions
i. All factors are variable.
ii. A worker works with given tools and equipment
iii. Technological changes are absent.
iv. Prevails perfect competition prevails
v. The output is measured in physical quantities.

73
Under the above assumptions, when all inputs are increased in unchanged proportions and the scale of
production is expanded, the effect on output shows three stages. In the first stage, returns of scale
increase because the increase in total output is more than proportional to the increase in all inputs. In the
second stage, returns to scale will become constant as the increase in total output is in exact proportion to
the increase in inputs. In the third stage, returns to scale diminish because the increase in output is less
than proportionate to the increase in inputs. In other words, if we increase all the inputs by 10 percent at a
time, then this total output will increase by more than 10 percent in the first stage, by I 0 percent in
second stage and by less than I 0 percent in the third stage. The principle of returns to scale can also be
explained as follows.

Returns to scale in physical units

Unit Scale of Productions Total Returns Marginal
In Quantities Returns
1 1 worker + 1 acre land 8 8

2 2 worker + 2acre land 17 9 Increasing

returns to
scale
3 3 worker + 3 acre land 27 10
4 4 worker + 4 acre land 38 11 Constant
returns to
scale
5 5 worker + 5 arc land 49 11
6 6 worker + 6 acre land 59 10
7 7 worker + 7 acre land 68 9 Diminishing
returns to
scale
8 8 worker + 8 acre land 76 8

The above table reveals that in the beginning with the scale of production of 1 worker+1 acre land the
total output is 8 quintals. When the scale of production is doubled, (2 workers + 2 acres land) total returns
are more than doubled as the production increased to 17 quintals. If we still increase the scale of
production to 3 workers + 3 acres of land, the total returns increase to 27 quintals. This is called stage of
increasing returns to scale. As the scale of production is further expanded, the total returns will increase in
such a way that the marginal returns become constant. In the case of 4 th and 5th units of the scale of
production, marginal returns remain constant at 11 quintals. It means that due to increase in inputs, there
is no additional increase in returns. This is the stage of constant returns to scale. Any increase in the scale
of beyond this will lead to diminishing returns. In the case of 6 th, 7th and 8th units, the returns increase at
lower rate than before so that the marginal returns start diminishing successively to 10,9 and 8. This is the
stage of diminishing returns to scale.

74
 Constant

Increase
C D

Marginal

Decrease
return
O X
In the above diagram, the OCDE curve represents the scale. From 0 to C due to increase in the scale of
production, the returns to scale are shown as increasing. From point C to D. the returns are constant and
from D to E they are diminishing.
Increasing Returns to Scale
Returns to scale increase because of the indivisibility of factors of production. This means the machines;
management, labor, finance etc. cannot be divided into smaller sizes to suit requirements of a production
firm. When a firm expands its size, the returns to scale increase because the indivisible factors are
employed to their maximum capacity. As the concept of indivisibility is vague, modern economists
attribute increasing returns to economies of scale and specialization. When a firm expands its size, the
returns to scale increase because the indivisible factors are employed to their maximum capacity. As the
concept of indivisibility is vague, modern economists attribute increasing returns to economies of scale
and specialization. When a firm expands its size, there is a wide scale for specialization of labor,
management and, machinery. Work is divided into several processes and sub-processes for better
concentration to increase efficiency. Thus, in the specialization and efficiency, output increases when the
size of the firm is expanded. It enjoys both internal and external economies of scale of production. The
firm may be able to install better machines, sell its goods more easily, borrow many at low cost, get raw
material at cheaper rate in larger quantities, and employ more professional managers. Further, it may also
enjoy external economies in terms of cheap credit and transport due to the concentration of a number of
firms at one place. Trade journal search and training will help in increasing the productive efficiency.
Constant Returns to scale
Increasing returns to scale accrue to a firm or industry only up to a point. As the firm is enlarged further,
internal and external economies are counter balanced by diseconomies of scale. Then, economies and
diseconomies balance each other. Output increases in the same proposition as an increase in the
proportion of inputs. Hence, constant returns to scale occur. If the inputs are doubled, output also doubles.
A production function, showing constant returns to scale is called linear and homogenous production
function or homogenous production function of first degree.

Diminishing Returns to Scale

If a producing firm continues to expand even beyond the point of constant returns, a stage comes when
diminishing returns to scale set in. This business may become unwieldy, and it brings problem of
supervision and co-ordination. Diseconomies of scale dominate economies of scale. Diseconomies may
75
arise either due to higher factor prices or from diminishing factor productivities. When an industry
expands its size, the demand for skilled labor, land, capital, etc rises And under the conditions of perfect
competition, intensive bidding raises wages, rent and interest. The prices of raw material may also grow
and there may be frequent breakdowns of machinery due to the difficulties involved in controlling them.
Returns to scale can be represented with the help of isoquants. The diagrams below show the increasing,
constant, and diminishing returns to scale

A Illustrates increasing returns to scale. Here, an increase in both inputs in a given proportion brings a
more than proportionate increase in output. Thus OM is greater than NP. If the factor price ratio P L/PK
remains unchanged, output expands along ray OD.

B Illustrates constant returns to scale. It shows that when we double both inputs, we double output. If we
triple all inputs, the output level is tripled i.e OG = GH = 1 + 1. The output expands along ray OE as long
as PL /PK remains unchanged.
C tells the diminishing returns to scale. Here, to double the output per unit of time, the firm must more
than a double the quantity of both inputs used per unit of time i,e OS is less than ST and ST is less than
TZ.

Exercise-1
1. What is meant by returns to scale?
___________________________________________________________________________________
___________________________________________________________________________________
___________________________________________________________________________________
2. List the assumptions of returns to scale.
___________________________________________________________________________________
___________________________________________________________________________________
76
___________________________________________________________________________________

8.3 ECONOMIES OF SCALE

A firm increases its size to take advantages of the benefits of large-scale production. After the Industrial
Revolution, it has become possible to introduce machinery on a large scale to expand output. The reason
for this development is to take advantage of some of the economies associated with large-scale
production. Economies of scale are nothing but reduction in production costs incurred in a firm either due
to its internal expansion or due to the concentration of a large number of firms at one place. The
economies of scale are of two kinds.
I. Internal Economies, and
II. External Economies
Internal Economies
These are the economies, which accrue to the firm when it expands output. These are internal economies
which arise within the firm as a result of own expansion. They arise due to increase in the scale of
production. These economies are enjoyed because of the use of methods, which small firms do not find it
worthwhile to employ.
a) Technical Economies: -Technical economies are those which arise due to adaptation of better
techniques of production, purchase of cost saving machines, and specialization in the production process.
b) Managerial economies: -These economies are due to the functional specialization within the
organization.
c) Commercial economies: -These are likely to arise from bulk purchase of materials and large-scale
production where per unit cost comes down and there is marketing advantages.
d) Financial economies: -large-scale business unit can borrow tend as at favorable rates of interest there
by minimizing the cost .
e) Risk-bearing economies: -A big firm can spread its risks and it will have the capacity to bear them by
diversifying its output. Diversification may be in terms of sources of supply of raw material and the
process of manufacturing.

External Economies
External economies are associated with localization of industry. They occur where an increase in the size
of an industry leads to lower costs for each individual firm in the industry. They accrue to each member
firm as a result of the expansion of the industry as a whole. The following are some of them.
a) Economies of concentration: -They relate to the advantage arising from the availability of skilled
workers, the provision of better transport and credit facilities, benefits from subsidiary industries etc.

77
b) Economies of Information: - They have better access of information on various fronts. It is possible to
have access to trade journals, magazines and establishment of research counters.
c) Economics of disintegration: -When an industry expands its size, it becomes possible to split up some
of the processes, which -are taken over by specialist firm. For example, a number of cotton mills which
are located in a particular locality may have the benefit of a calendaring plant.

8.4 LAW OF SUPPLY

Supply means the quantity of a commodity that a seller is willing and able to offer for sale. If the price
goes up, the producer will offer more for sale. But, if the price goes down, he will be unwilling to sell and
will offer less to sell. Hence, supply varies with a change in price and it is always made at a price. Just as
demand implies willingness and ability to pay, "Supply implies willingness and ability to deliver the
goods". There is a difference between the terms 'stock' and “supply”. Stock constitutes potential supply.
But supply means the quantity actually offered for sale at a certain price. Stock is that which can be
offered for sale if the conditions are favorable.

Factors influencing supply include:

i. The price of commodity,
ii. Prices of other commodities,
iii. Price of the factors of productions and,
iv. The state of technology.
Supply Schedule
A supply schedule is a statement of the various quantities of given commodities, offered for sale at
various prices at a particular point of time. The following table shows a hypothetical supply schedule for
mangoes.

Table: Supply Schedule

Price per kgs. Quantity
In Birr in Kgs.
5 400
4 300
3 200
2 100
1 50
In the above schedule you may notice that when the price falls, less mangoes are offered for sale and
when the price rises, the seller is prepared to sell more of them. The simple explanation here is that the

78
higher the price of commodity, the greater are the profits that can be earned and thus, the greater the
incentive to produce the commodity to offer it for sale.

In this diagram, the quantities of mangoes are measured alone on OX axis and prices along OY axis.
The supply curve SS slopes upward as we go from left to right.

This means that as the price rises, more supply is offered for sale and vice-versa.
This supply curve is related to the cost structure of the firm.

Law of Supply
In a given market at any given time, the quantity of any good which people are ready to offer for sale
generally varies directly with the price.

Exceptions
1. When prices are expected to fall greater, sellers sell more in order to clear their stocks. This will
happen in the short-run.
2. In the long run, the supply is influenced by changes in costs, which are in turn affected by changes in
technology.
3. Changes in habits, tastes, fashions, weather etc. also affect the supplies of commodities.

8.5 ELASTICITY OF SUPPLY

It is the degree of responsiveness of the supply to change in price. It may be defined as the percentage
change in quantity supplied divided by the percentage change in price. Elasticity of supply can be
measured with the help of the following formula.
Es = Change in amount supplied ÷ Change in price
Original amount supplied Original price
79
= Q÷ P
Q P
'Q' refers to the quantity supplied and 'p’ to the price and represents change. The supply is elastic when
with a small change on price there is great change in supply. It is inelastic or less elastic when a great
change in price induces only a slight change in supply. If the supply is perfectly inelastic, it will be
represented by a vertical line shown below.
S

Infinite elasticity
perfection elastic
Perfectly inelastic
P
or zero elasticity
Price

Price
Y Y S
O
Supply X O Supply X

The above chart represents zero elasticity in which the quantity supplied does not change as price
changes. If supply is perfectly elastic, it will be represented by a horizontal straight line as in second
diagram. At 'OP' price, the supply elasticity is infinite because nothing at all is supplied at lower prices.
Producers would supply any quantity demanded at the price.

8.6 SUMMARY

Laws of returns to scale and different economies of scale are presented in this unit. Laws of returns to
scale explain the changes in output when all factors of production move in the same direction and with
equal proportion.

8.7 ANSWERS TO CHECK YOUR PROGRESS EXERCISES

1. Returns to scale means the effect of scale relationship. The term returns to scale refers to change
in output as all factors change by the same proportion.
2. i) All factors are variable
iii) A worker works with given tools and equipment
iv) Technological changes are absent
iv) The output is measured in physical units
80
8.8 MODEL EXAMINATION QUESTIONS

1. Explain the laws of returns to scale

2. What is meant by elasticity of supply?
3. Explain economies of scale
4. Mention the exceptions to the law of supply
5. What is elasticity of supply?

8.9 REFERENCES

 Varian. R Hall (1999) Intermediate microeconomics.

 Koutseyianniss,A (1985) Modem microeconomics.
 Gonld and Furguson (1985) microeconomic theory.
 Jhingan, M.L (1998) microeconomic theory.
 Barthwal. R.R (1992) microeconomic theory.

UNIT 9: COST ANALYSIS

Contents
9.0 Aims and Objectives
9.1 Introduction
9.2 Types of Costs
9.3 Relationship between Production and Costs
9.4 Short-run Cost Functions
9.5 Long-run Cost Functions
9.6 Summary
9.7 Answers to Check Your Progress Exercises
9.8 Model Examination Questions
9.9 References

9.0 AIMS AND OBJECTIVES

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The purpose of this unit is to discuss the meaning of cost,its types of cost and the relationship between
costs and productions.
After studying this unit, you will be able:
 Understand the meaning of cost,
 Classify cost,
 Explain the relationship between cost and production,and
 Distinguish among average, marginal, and total costs.

9.1 INTRODUCTION

Cost and revenue are the two major factors that a profit-maximizing firm needs to monitor continuously.
It is the level of cost relative to revenue that determines the firm's overall profitability. In order to
maximize profits, a firm tries to increase its revenue and lower its cost. While the market factors
determine the level of revenue to great extent, the cost can be brought down either by producing the
optimum level of output using the least cost combination of inputs, or increasing factor productivities, or
by improving the organizational efficiency. The firm’s output level is determined by its cost. Product
prices are determined by the interaction of the forces of demand and supply. The basic factor underlying
the ability and willingness of firms to supply a product in the market is the cost of production. Thus, cost
of production provides the floor to pricing. It is the cost that forms the basis for any managerial
decisions like which price to quote, whether to accept a particular order or not, whether to abandon or add
a product to the existing product line, whether or not to increase the volume of output, whether to use idle
capacity or rent out the facilities, whether to make or buy a product, etc. However, it is essential to
underline here that all costs are not relevant for every decision under consideration.

9.2 TYPES OF COSTS

There are many types of costs that a firm may consider relevant for decision-making under varying
situations. The manner in which costs are classified or defined is largely dependent on the purpose for
which the cost data are being outlined.
Explicit and Implicit Costs
Explicit: The expenses which are incurred by a firm in buying and services directly are known as explicit
costs. Monetary expenses incurred by a producer to hire workers, purchase of raw materials, power etc
are explicit costs.
Implicit-costs: The expenses which are owned are inputed for self owned and self- employed resources,
salary of the owner of firm, rent on own building etc are called implicit costs.
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Money Cost and Real Costs
Money Costs: -A firm usually incurs money expenses for producing a commodity. It may spend money
on wages, salaries, raw materials, plant, equipment, etc. These are called money expenses.
Real Costs: -
Real costs are those where the members of the society make sacrifices in their efforts to produce a
commodity. These sacrifices and efforts are the real cost of production. Workers forego leisure, capitalists
save and invest, landlords use land for production. These kinds of sacrifices and efforts of the members of
the society are called cost of production.

Opportunity Cost of Alternative Cost

The opportunity cost (or cost of the foregone alternative) of a resource is a definition cost of the most
basic. While this particular definition of cost is the preferred baseline for economists in describing cost,
not all costs in decision-making situation are completely obvious; one of the skills of a good manager is
the ability to uncover hidden costs. For along time, there has been considerable disagreement among the
economists and accountants. Opportunity cost has been defined by economists as the cost of production
of a commodity that could have been alternatively used instead. According to Bentham, "The opportunity
cost of anything is the next best alternative that could be produced instead, by same factors, or by an
equivalent group of factors, costing the same amount of money." Richard G. Lipsey defined it as "The
cost of using something in a particular venture is the benefit forgone by (an opportunity cost of) not using
it in its best alternative use". Opportunity cost has great importance when applied to economic problems.
It can be plied in the determination of factor prices. It can also be applicable to consumption and public
expenditure. It explains the phenomena of price. As the resources are scarce, they would be put to
alternative uses, that is why there arises the need to understand the opportunity cost.

Direct and Indirect Costs

There are some costs, which can be directly attributed to production of a given product use of raw
material, labor, input and machine. Time involved in the production of each item unit can usually be
determined. On the other hand, there are certain costs like stationery and other office and administrative
expenses, electricity changes, depreciation of plant buildings, and other such expenses that cannot easily
and accurately be separated and attributed to individual limits of production except on arbitrary basis.
Direct and indirect costs are not exactly synonymous to what economists refer to as variable costs and
fixed costs. The criterion used by the economist to divide cost into either fixed or variable is whether or
not the cost varies with the level of output, whereas the accountant divides the cost on the basis of
whether or not the cost is separable with respect to the production of individual output units.

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Private Costs Vs Social Costs
Private costs are those that relate directly to the individuals of firms engaged in relevant activity. External
costs, on the other hand, are passed on to the persons not involved in the activity in any direct way. While
the private cost to the firm of dumping is zero, it is definitely positive to the society. It affects negatively
the people located down, currently who are adversely affected and incur higher costs in terms of treating
the water for their use, or having to travel a great deal to fetch potable water. If those external costs were
included in the production costs of the producing firm, a true picture of real or social costs of the output
would be obtained. Ignoring external costs may lead to an inefficient and undesirable allocation of
resources in society.

Relevant Costs and Irrelevant Costs

The relevant costs for decision-making purposes are those costs, which are incurred as a result of the
decision under consideration. The relevant costs are also referred to as the incremental costs. Costs that
have been incurred already and costs that will be incurred in the future regardless of the present decision
are irrelevant costs as far as the current decision problem is concerned.
There are three main categories of relevant or incremental costs. These are the present- period explicit
costs, the opportunity costs implicitly involved in the decision, and the future cost implications that flow
from the decision. For example, direct labor and material costs, and changes in the variable overhead
costs are the natural consequences of a decision to increase the output level. Also, if there is any
expenditure as capital equipment incurred as a result of such a decision, it should be included in full, not
withstanding that the equipment may have a useful life remaining after the present decision has been
carried out. Thus, the incremental costs of a decision to increase output level will include all present
period explicit costs, which will be incurred as a consequence of this decision. It will exclude any present-
period explicit cost that will be incurred regardless of the present decision. The opportunity cost of a
resource under use becomes a relevant cost while arriving at the economic profit of the firm.
Economic Cost and Profits: - Profits are the firm's total revenue loss its explicit costs. But economists
define profits differently. Economic profits are total revenue less all costs (explicit and implicit).
Therefore, when an economist says that a firm is just covering its costs, it is meant that all explicit and
implicit costs are being met, and that, the entrepreneur is receiving a return just large enough to retain his
or her talents in the present line of production. If a firm’s total receipts exceed all its economic costs, the
residual accruing to the entrepreneur is called an economic, or pure profit.
Economic profit = Total revenue -Opportunity cost of all inputs

Economic Profits Accounting Profits

Total Revenue Economic or Opportunity cost Accounting costs

84
Separable and Common Costs
Costs can also be classified on the basis of this tractability. The costs that can be easily attributed to a
product, a division, a process are called separable costs, and the rest are called non-separable or common
costs. The separable and common costs are also referred to as direct and indirect costs. The distinction
between direct and indirect costs is of particular significance in a multi-product firm for setting up
economic prices for different products.

Fixed and Variable Costs

Fixed costs are those costs, which in total do not vary with changes in output. Fixed costs are associated
with the very existence of a firm's plant and therefore must be paid even if the firm's rate of output is zero.
Such costs as interest are borrowed capital, rental payments, a portion of depreciation charges of
equipment and buildings’ and the salaries of top management and key personnel are generally fixed costs.
On the other hand, variable costs are those costs, which increase with the level of output. .They include
payment for raw materials, charges on fuel and electricity, wages and salaries of temporary staff,
depreciation changes associated with wear and team of assets, and sales commission, etc.
This distinction is true only for the short run. The costs associated with fixed factors are called the fixed
costs and the one associated with variable factors, the variable costs. Thus, if capital is the fixed factor,
capital rental is taken as the fixed cost, and if labor is the variable factor, wage bill is treated as the
variable cost.

85
Exercise -1
1. What is an opportunity cost?

___________________
2. Distinguish between fixed and variable costs.

__________________________________________________________________

9.3. RELATIONSHIP BETWEEN PRODUCTION AND COSTS

The concept of cost is closely related to production theory. A cost function is the relationship between a
firm's costs and the firm's output. While the production function specifies the technological maximum
quantity of output that can be produced from various combinations of inputs, the cost function combines
this information with input price data and gives in formation on various outputs and their prices. The cost
function can thus be thought of as a combination of the two pieces of information i.e., production function
and input prices.
Let us consider a short-run production function with only one variable input. As we have already seen in
the previous unit, the diminishing returns to the variable input set in after a point. The output grows at an
increasing rate in the initial stages implying increasing returns to the variable input, and then diminishing
returns to the variable input start. Assuming that the input prices remain constant, the above production
function will yield the variable cost function, which has a shape that is characteristic of many variable
cost functions; increasing at decreasing rate and then increasing at an increasing rate. This relation
between the total product curve and the total variable cost is shown in Figure I.

Figure I

86
This time has a production function that exhibits increasing returns to the variable factor input (labor)
upto L * and decreasing returns after L *, The input level L * corresponds to the output level Q*; The
variable cost function increases at a decreasing rate up to Q* and at an increasing rate beyond Q*.
From this, you should be able to derive a relationship between average product and average costs, and
marginal product and marginal costs. For example,
TVC=Pr.V

AVE = TVC= Pr. V = Pr. and

Q Q Q/V
MC= TVC= Pr. V = Pr.
Q Q  Q/ V

where Pr stands for the price of the variable field and r for amount of variable factors.
You may note that Pr being given, A VC is inversely related to the average product of the variable factors.
In the same way, given the wage rate MC is inversely related to the marginal product of labor.

9.4 SHORT-RUN COST

The short-run is normally defined as a time period over which some factors of production are fixed and
others are variable. These periods are not defined by some specified length of time, but rather are
determined by the variability of factors of production. Thus, what one firm may consider in the long run
may correspond to the short-run for another firm.
In the short run, a firm incurs some costs that are associated with variable factors and others that result
from fixed factors. The former are called variable costs and the latter represent fixed costs, Variable
Costs (VC) change as the level of output changes and therefore can be expressed as a function of output
(Q), that is VC = f(Q) variable costs typically include such things as raw material, labor and utilities. In
column 3 of table 1, we find that the total of variable costs changes directly with output. But note that the
increases in variable costs associated with each one-limit increase in output one, not constant. As
production begins, variable costs will, for a time, increase by a decreasing amount.This is true through the
fourth unit of the output. Beyond the fourth unit, however, variable costs rise by increasing amount for
each successive unit of output. The explanation of this behavior of variable costs lies in the law of
diminishing returns.

87
Table 1
Total and average-cost schedules for an individual firm in the Short-run

(Hypothetical Data in Birr)

Total Cost data, per week Average- cost data, per week
(1) (2) (3) (4) (5) (6) (7) (8)
Total Total Total Total cost (TC) Average Average Average total Marginal cost
product fixed cost variable TC=TFC+TVC fixed cost variable cost cost (ATC) (MC) MC=change
(TFC) cost(TVC) (AFC) (AVC) ATC=TC/Q in TC change in Q
AFC=TFC/Q AVC=TVC/Q

0 100 0 100
1 100 90 190 100.00 90.00 190.00 90
2 100 170 270 50.00 85.00 135.00 80
3 100 240 340 33.33 80.00 113.33 70
4 100 300 400 25.00 75.00 100.00 60
5 100 370 470 20.00 79.00 94.00 70
6 100 450 550 16.67 75.00 91.67 80
7 100 540 640 14.29 77.14 91.43 90
8 100 650 750 12.50 81.25 93.75 110
9 100 780 880 11.11 86.67 97.78 130
10 100 930 1030 10.00 93.00 103.00 150

Fixed costs, on the other hand, are not a function of the level of output and are constant in the short-run,
that is, FC = K. Fixed costs may include such things as property, the costs of lease on hand, buildings and
some types of equipment, interest changes on the long- term formed funds, and insurance costs. In
column 2 of table 1, we have assumed that the firm's total fixed cost is 100 birr. This fixed cost figure
prevails at all levels of output including zero. The distinction between fixed and variable costs is of great
significance to the business manager. Variable costs are those costs which business can control or after in
the short- run by changing levels of production. On the other hand, fixed costs are included in the short-
run and must be paid regardless of output level.

Total Cost
Total cost is the sum of fixed and variable cost at each level of output. It is shown in column 4 of table 1.
At zero unit of output, total cost is equal to the firm’s fixed cost. Then for each limit of production, total
cost varies at the same rate, like variable cost. The figure below shows the fixed, and total cost data of
table 1.

88
Per unit, or average costs
Besides their total costs, producers are equally concerned with their cost per unit, or average costs. In
particular, average cost data is more relevant for making comparisons with product price, which is always
stated as per unit basis. Average fixed cost, average variable cost, and average cost are shown in columns
5 to 7 of table 1. It is important that we know how these unit-cost figures are derived and how they vary
as output changes.

Average fixed cost

Average fixed cost (AFC) is derived by dividing total fixed cost (TFC) by the corresponding output. (Q).
That is
AFC = TFC
Q

While total fixed cost is, by definition, independent of output, AFC declines so long as output increases.
As output increases, a given total fixed cost of 100 Birr is obviously being spread over a larger and larger
output. This is what business executives commonly refer to as 'spreading the overheads'. We find in
Figure III that the AFC cause is continuously declining as the output is increasing. The shape of this curve
is of an asymptotic hyperbola.

89
Average Variable costs
Average variable cost (A VC) is found by dividing total variable cost (TVC) by the corresponding output
(Q).
AVC= TVC
Q

A VC declines initially, reaches a minimum, and then increases again. Graphically, this provides as with a
Costs (Birrs)

V -shaped or same shaped A VC curve, as shown in Figure -III

Figure III Average Fixed, Variable and Marginal Costs

Quantity

Total variable cost reflects the law of diminishing returns, This is also relfled by AVC figures, so must
the
AVC figures, which one derived from total variable cost. Because of increasing returns initially, it takes
fewer and fewer additional variable resources to produce each of the first units of output. As a result,
variable cost per unit will decline. Thus, AVC hits a minimum with the fifth unit of output, and beyond
this point AVC rises as diminishing returns recipient the use of more and more variable resources to
produce each additional unit of output.

90
Average Total Costs
Average total cost (ATC) can be found by dividing total cost (TC) by total output (Q) or, by adding AFC
and A VC for each level of output. That is:
ATC= TC=AFC+AVC
Q
These data are shown in column 7 of Table 1. Graphically, ATC is found by adding vertically the AFC
and
AVC curves, as in Figure III. Thus, the vehicle distance between the ATC and AVC curves reflects AFC
at any level of output.

Marginal Cost
Marginal cost (MC) is defined as the extra, or additional, cost of producing one more unit of output. MC
can be determined for each additional unit of output simply by noting the change in total cost which unit's
production entails:
MC = Change in TC = TC
Change in Q Q
Our data in table 1 is so structured that the "Change in Q" is always "1", so we have defined MC as cost
of one more unit of output. However, the same concept can be extended for situations where Q is more
than 1. Arc marginal cost (over a large of output) can be found by using the above expression.
The marginal cost concept is very initial form of the manager's point of view. Marginal cost is a strategic
concept because it designated those costs on which the firm has the most direct control.. More
specifically, MC indicates those costs which are incurred in the production of the last limit of output and,
therefore also the cost which can be "saved" by reducing total output by the last unit.
Average cost figures do not provide this information. A firm's decisions as to what output level to
produce is largely influenced by its marginal cost. When coupled with marginal revenue, which indicates
the change in revenue from one more or one less unit of output, marginal cost allows a final to determine
whether it is profitable to expand or contact its level of production.
Marginal cost is shown graphically in Figure Ill. Note that marginal cost declines sharply, reaches a
minimum and then rises rather sharply. This mirrors the fact that variable cost, and therefore total cost,
increased first by decreasing amounts and then by increasing amounts (Figure I)

MC and Marginal Product

The shape of the marginal cost curve is a reflection of, and the consequence of, the law of diminishing
returns. If each successive unit of a variable input say labor is hired at C constant price, the marginal cost
of each extra limit of output will fall so long as the marginal product of each additional worker is rising.
This happens because marginal cost is simply the constant wage (cost) of an extra worker divided by his
91
or her marginal product. Thus, given the price (cost) of the variable resource, increasing returns i.e., a
rising marginal product, will be reflected in a declining marginal cost and diminishing returns i.e., falling
marginal product, in a rising marginal cost. The NC curve is a mirror reflection of the marginal product
curve; this relationship is shown in figure IV. It is clearly shown that when marginal product is rising,
marginal cost is necessarily falling. 'When marginal product is at its maximum, marginal cost is at its
minimum. And when marginal product is falling, marginal cost is rising.

Relationship of MC to AVC and ATC

It is also notable that marginal cost cuts both A VC and A TC at their minimum (Figure 1lI), when both
the marginal and average variable costs are falling, average total cose will fall at a slower rate. And when
MC and A VC are both rising, MC will rise at a faster rate. As a result, MC will attain its minimum
before the AVC. In other words, when MC includes AVC, AVC will rise. This means (Figure III) that so
long as MC lies below AVC, the latter
will fall and where MC is above AVC,
AVC will rise. Therefore, at the point of
intersection where MC = AVC, AVC
has just ceased to fall and attained its
minimum, but has not yet begun to rise.
Similarly, the marginal cost curve cuts
the average total cost curve at the
latter's minimum point. This is because
MC can be defined as the addition either
to total cost or to total variable cost
resulting from one more unit of output
However, such relationship exists
between MC and the average fixed cost,
because the two are not related.
Marginal cost by definition, includes
only those costs, which change with
output, and fixed costs by definition are
independent of output.

Figure IV
The Relationship between
productivity curves and cost
curves

92
Marginal uses of the short-run cost concepts
As already emphasized, the relevant costs to be considered for decision-making will differ from one
situation to the other depending on the problem faced by the manager. In general, the total cost concept is
quite useful in finding out the break-even quantity of output. The total cost concept is also used to find
out whether firm is making profits or not. The average cost concept is important for calculating the per
unit profit of business firms. The marginal and incremental cost concepts are essential to decide whether
a firms should expand their production or not.
These LAC and LMC and values are graphed in Figure VII. We see, both in the table and in the graph,
that LAC and LMC are V -shaped and that they are equal at the minimum of LAC. The values of LMC
are graphed at the midpoints of the output intervals they represent.

Out Put

9.5 Long- Run Average Cost as an Envelope Curve

The long-run average cost curve is sometimes shown as the envelope curve of series of the possible short-
run average cost curves, as shown in Figure VIII. Five short-run average cost curves, each representing a
different sized plant (or set of fixed factors) are illustrated although many more may exist, the long-run
ATC curve shows the least per unit cost as any output can be produced after the firm has had time to
make all appropriate adjustments in its plant size. Consider, for example, the production of Q* units in
figure Vll. That the level of output could be a produced with the plant sizes represented by SACl, SAC 2 or
SAC3. It represents the optimum rate of output for the plant size represented by SAC} (i.e., it is at the

93
minimum point of SAC). However, if the firm expects to produce at the rate, the best size of plant is the
one related to SACz. Q* units could be produced at cost savings of FB per unit over SAC2.

Figure VIII
Long-run Average Cost as an Envelope Curve

The plant size associated with SAC 2 is the optimum size plant because its premium point is the lowest of
all possible unit costs. Given the LAC in figure VIII, we can say that these are increasing returns to scale
(or economies of scale) up to Qo and decreasing returns to scale (or diseconomies of scale) beyond Qo.
The firm's LAC curve is often called the 'firm's planning curve'.

9.6. SUMMARY

This unit has presented the meaning and various kinds of costs, the relationship among the marginal cost,
average cost, and total costs

9.7 ANSWERS TO CHECK YOUR PROGRESS ECERCISES

i) Opportunity cost as the cost of using something in a particular venture is the benefit forgone by not
using it in its best alternative use.
ii) Fixed cost is one which remains constant irrespective of the output up to a certain level of activity.
Variable cost is the cost, which varies directly with the output.

94
9.8 MODEL EXAMINATION QUESTIONS

1. What do we mean by long- run cost?

2. Explain the relationship between average cost and marginal cost.
3. What is direct cost?
4. Explain money costs and real costs.

9.9 REFERENCES

 Varian. R Hall (1999) Intermediate microeconomics.

 Koutseyianniss, A (1985) Modem microeconomics.
 Gon1d and Furguson (1985) microeconomic theory.
 W Jhingan, M.L (1998) microeconomic theory.
 W Barthwal, R.R (1992) microeconomic theory.

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Unit 10: REVENUE ANALYSIS

Contents
10.0 Aims and Objectives
10.1 Introduction
10.2 Types of Revenue
10.3 Revenue Curves in Perfect Competition
10.4 Revenue Curves in Monopoly
10.5 Relationship between AR and MR Curves
10.6 Relationship among AR, MR, and Elasticity of Demand.
10.7 Special Cases of Revenue Curves
10.8 Summary
10.9 Answers to Check Your Progress Exercises
10.10 Model Examination Questions
10.11 References

10.0 Aims and Objectives

This unit identifies the concepts of revenue analysis and revenue curves in perfect competition and
monopoly. It also discusses the relationship among AR, MR, and elasticity of demand.
After going through this unit, you will be able to: define the concepts of revenue, TR, AR and MR and
distinguish between AR and MR.

10.1 INTRODUCTION

The concept of revenue is necessary to understand the notion of equilibrium of a firm. An attempt is made
to explain the kinds of revenue and their diagrammatic presentation

10.2 TYPES OF REVENUES

Revenues are classified in to three kinds: total revenue, average revenue and marginal revenue.
Total Revenue (TR)
A firm's total revenue is the quantity of goods sold multiplied by the price. Suppose a firm sells 10 books
and receives Br. 200. This amount is called total revenue
√TR =Quantity x price

96
Average revenue (AR)
Average revenue is nothing but the price per unit. This can be derived by the firm's total revenue divided
by the number of goods sold. Suppose a firm receives Br. 200 by selling 10 books, Average revenue from
is these books calculated as follows

√AR = Average Revenue

Output sold
=200
10
=20
AR =Average Revenue
TR = Total Revenue

Marginal Revenue
Marginal revenue is the change in total revenue received by selling an additional unit of the commodity.
By selling an additional unit, a firm earns additional revenue which adds to the total revenue and this
additional revenue is called marginal revenue. Suppose a firm receives a total revenue of Br. 18 by selling
3 books and it receives a total revenue of Br. 20 by selling a 4th book. Then the marginal revenue is Br. 2

√ MR = TR of 4 books -TR of 3 books =20-18 =2

Table 10.1 Total~ Average and Marginal Revenue Schedule

No of Unit Sold Price or average Total Revenue(TR) Marginal

Revenue Revenue(MR)
1 8 8 -
2 7 14 6
3 6 18 4
4 5 20 2
5 4 20 0
6 3 18 -2
7 2 14 -4

The law of demand states that when price falls demand increases. Suppose, as in table 10.1, that a firm
sells 3 units at price 6. The firm reduces the price of the product so as to attract the consumers or buyers.
If the firm reduces the price of the product from 6 to 5, it now sells 4 units. The total revenue of units is
18 birr (price birr 6x 3 units sold) and the total revenue of 4 units is 20 (price birr 5x4 unit sold). Thus,
MR = TRn+l -TRn

97
MR = TR of 4 units -TR of 3 unit MR=Br. 20-Br.18 =Br. 2
Marginal revenue can also be computed by using the second equation. According to the law of demand,
more goods will be offered at a lower price. In table 10.1, the firm offers 3 units at a price of Birr 6. The
firm sells 4 units of the commodity by reducing the price to Birr 5. This involves a loss in revenue on the
previous goods due to the reduction in price. When the price is Birr 6, only 3 units were sold and when
the price fell to Birr. 5 the firm sold 4 units. This must be understood to mean that the previous unit plus
the additional unit are also sold at Birr 5. It is necessary to reduce the price of the previous goods to the
selling price of the 4th article. There is a loss of 1 Birr on each of the previous 3 units. The total loss in
revenue on the previous ‘n’ (or 3 units) is Birr 3. This loss in revenue of Birr 3 must be deducted from
the price (birr5) of the last unit sold or (n+1)th unit or 4th sold. Thus,
MR= Price of (n+1)th (or 4th) unit-Loss in revenue on previous ‘n’ (or 3)
MR= Br.5-Br.3 =Br.2
For instance, when 2 units are sold, the marginal revenue is Birr. (14-8); when 3 units are sold, it is Birr
4(18-14) and so on. It is obvious from table 10.1 that the decrease in average revenue will be less than
the decrease in marginal revenue. When price is reduced say from Birr 7 to 6, the decrease in average
revenue is only Birr 1 (7-6) and decrease in marginal revenue is Birr 4(18-14).
Average and marginal revenue curves can be drawn for the above data. The quantity of the commodity is
measured on the OX-axis and the revenue on the OY-axis. As the decrease in marginal revenue will be
higher than the one in revenue, the marginal revenue will be less than average revenue at all levels. When
price decreases from Birr 5 to 4, the marginal revenue is zero and the MR cuts the X-axis.

98
When the price is reduced from bin- 4 to Birr 3, 6 units of the commodity are sold and at this level
marginal revenue become negative. Total revenue also comes down from Birr 20 to Birr 18. This is a
general diagrammatic representation of marginal revenue ,and average revenue.

Exercise-1
1. What is total revenue?
___________________________________________________________________________________
___________________________________________________________________________________
___________________________________________________________________________________
2. What is average revenue?
___________________________________________________________________________________
___________________________________________________________________________________
___________________________________________________________________________________

10.3 REVENUE CURVES IN PERFECT COMPETITION

Normally, average revenue (price) is greater than marginal revenue as shown in figure 10.1,but in perfect
competition, an individual firm cannot influence the ruling price, so the firm can offer any quantity of the
goods at the given market price. Marginal revenue is equal to average revenue because there is no loss in
the previous units.
Table 102: Demand and Revenue Schedule of a Firm in Perfect Competition (in Birr)

No of unit Average Revenue or Total Marginal

sold price (AR) Revenue(TR) Revenue(MR)
(1) (2) (3) (4)
1 10 10 10
2 10 20 10
3 10 30 10
4 10 40 10

In perfect competition as there are a huge number of firms, the price of the product is not determined by a
single firm or an individual. When there is no change in the market price, if more goods are sold at the
same price, the marginal revenue will be equal to the average revenue (MR=AR). Table 10.2 shows the
demand and revenue schedule of a firm in perfect competition. Let us suppose that we assume the market
price remains constant at Birr 10 As demand increases the firm will prefer to' sell any quantity of the
99
goods at the existing price. Suppose the firm sells one commodity at price 10, it earns a total revenue of
Birr 10 only. If it sells 2 units at the same price, it receives a total revenue of Birr 20. By selling an
additional unit i.e., the 2nd unit, it gets a net revenue or additional revenue or marginal revenue of 10 Birr
(Birr 20-10). As more and more units are offered at the same market price, the total revenue will increase,
but there will be no change in marginal revenue. The rate of increase in total revenue will be the same as
the average revenue or price and will be equal to the marginal revenue.

40-

30-

20-
Revenue

10-
O 10 20 30 30 X
Quantity

Fig. 10.2 Total Revenue Curve in Perfect Competition

In figure 10.2, we have drawn a total revenue curve(TR). As the quantity sold increases at the ruling price
the total revenue also increases. When one unit is sold, the total revenue is 10; when 2 units are sold at the
same price, the total revenue is Birr 20 and so on. The total revenue curve (TR) rises upwards from left to
right.

Y INDIVIDUAL FIRM
Price

AVERAGE REVENUE
P L MR=AR
MARGINAL REVENUE

O X
QUANTITY

Fig. 10.3 Average and Marginal Revenue Curves in Perfect Competition

100
In figure 10.3, we have drawn the average revenue (AR) and marginal revenue (MR) curves. The firm
sells any quantity of output at the given price, Birr 10.The price being constant in perfect competition, as
the volume of output increases the total revenue increases, but the additional revenue received (MR) by
selling an additional unit is equal to the price (AR). Hence, the marginal revenue curve coincides with the
average revenue curve. In figure 12.3, at a price of Birr 10, the average revenue and marginal revenue are
the same straight line curve PL, which is parallel to OX -axis.

10.4 REVENUE CURVES IN MONOPOLY

In imperfect competition, a competition where the assumptions made under perfect competition will not
prevail, the demand curve or average revenue curve of a firm is less than perfectly elastic. This means
that the average revenue curve has a negative slope- and the marginal revenue curve lies below the
average revenue curve. In monopoly, there is only one seller or producer in the market. He clears off his
goods according to the market because he reduces the price of the goods. If the monopoly firm offers
more goods at a lower price, it is clear that the average revenue curve will fall and the marginal revenue
curve which lies below the average revenue curve will also fall. This phenomenon can easily be
understood from the following imaginary demand and revenue schedules for a firm under monopoly.

Table 10.3: Demand and Revenue Schedule for a Firm in Monopoly

Quantit Average Revenue Total Marginal
of X or price (AR) Revenue (TR) Revenue (MR)
(1) (2) (3) (4)
1 7 7 -
2 6 12 5
3 5 15 3
4 4 16 1
5 3 15 -1

In table 10.3. Columns 1 and 2 represent the relationship between demand and price. This relationship
gives the demand curve of the monopolist. As price falls the demand for the commodity will increase.
When the price falls from Birr 7 to Birr 6, the demand increases from one unit to two units. But the total
revenue increases from Birr 7 to Birr 12. This is shown in column 3.The total revenue can be obtained by
multiplying the quantity demanded and the price of the product. By selling an additional unit, the
monopolist receives net revenue which is called marginal revenue as shown in column 4. If one unit of
the products is sold, he earns a total revenue of Birr 7. If he sells 2 units at the reduced price of Birr 6, he
gets a total revenue of Birr 12. the marginal revenue of the second unit can be derived by subtracting the
101
total revenue of one unit sold from the total revenue of 2 units sold. For example, the marginal revenue of
the second unit is Birr 12-7=5. Similarly, the marginal revenue of other units can also be obtained.

These facts can be explained with the help of a diagram. It is clear from figure 10.4 that the demand curve
or average revenue curve (AR) is sloping downward to the right. This indicates that more commodities
are sold as the price falls. Marginal revenue (MR) is the corresponding marginal revenue curve. This
curve is also sloping -downward to the right but it lies below the average revenue curve at all levels.

Fig. 10.4 Average and Marglinal Revenue Curves in

Monopoly
In figure 10.5,
TR is the total
revenue curve.
Total revenue
increases as the
sale of
commodities increases due to a reduction in the price of the
product. The rate of increase in total revenue is not the same
as in perfect competition, but it increases at a diminishing
rate. Total revenue increases up to the sale of 4 goods only.
If the price is further reduced, more goods will be sold but
the total revenue will decline.

10.5 RELATIONSHIP BETWEEN AR AND MR CURVES

102
Here, we shall concern ourselves with the AR and MR curves in the analysis of the theory of price. The
relationship between AR and MR has to explain to some extent. Now, we have to explain the relationship
between the AR curve and the corresponding MR curve geometrically with the help of the following
figure.

QUANTITY
Fig. 10.6 Relationship between Average and Marginal Revenue Curve

As shown in figure 10.6, MR must be less than AR, as long as ARC is falling. The MRC normally falls
downwards. Sometimes it may be horizontal or rising depending on the market situations. In the case of a
straight line, the AR and MR curves fall downwards and MRC is lower than ARC. The rate of fall in
marginal revenue curve is double that of the rate of fall in AR curve. If we draw a perpendicular line from
AR to the OY axis, the MR curve, the dotted line, cuts the perpendicular line when it is half way to AR
curve. In figure 10.6, PR =RS

10.6 RELATIONSHIP AMONG AR, MR, AND ELASTICITY OF DEMAND

103
The relationship between average revenue and marginal revenue at any level of out put has been
explained earlier. This has great importance in economic analysis. The demand curve of a firm is the
same as the average revenue curve. Here, we shall study the relationship between average revenue,
marginal revenue, and elasticity of demand. The elasticity of demand is measured on the average revenue
curve in figure 1 0.7

In Fig. 10.7, the elasticity of demand at point 'R' is equal to the lower segment SB/upper segment SA. The
elasticity of demand can be defined as:

proportionate change in the

quantity demanded for X
Elasticity demand =
Proportionate change in the
price of X
We can write the formula of elasticity of demand in the following manner

AR
ŋd =
AR-MR
ŋd (AR -MR) = AR
ŋd. AR -ŋd .MR = AR
104
 ŋd .AR-AR=ŋd. MR
MR = ŋ.d AR-AR
ŋd
MR= AR (nd-1)
nd
MR =MR (1-1/ŋd)
Where, MR= Marginal Revenue
AR= Average Revenue, and
ŋd = elasticity of demand
On the basis of the formula derived above, we can find out the relationship between MR and AR at
different points of elasticity of demand as in the figure drawn below.

G QUANTITY
MR CURVE
Fig 10.8: AR and MR
At point C on the AR curve or PN, the elasticity of demand is
equal to 1.
MR= AR (1-1nd)
MR= AR (1-1/1) =AR (1-1)=AR (0)=0
1 1
The marginal revenue curve is zero, when it touches the OX axis at point D. When the elasticity of the
AR curve is unity, the marginal revenue is always zero. If the elasticity of AR curve at point A is greater
than unity, say at 2.
MR = AR 2-1 = 1/2AR
2
It indicates that when the elasticity of AR is greater than one, the MR is always positive. It is MB in
Figure 10.8
105
If the elasticity of the AR curve is less than unity say' 1/2',
1/2-1 = -1/2
MR= 1/2 2/1 = ½ x 2/1=-1.

The MR is negative at point F on AR curve. If the elasticity is less than unity, MR is negative to TG.

10.7 SPECIAL CASES OF REVENUE CURVES

There are many special cases of average and marginal revenue curves, which have been explained by
Mrs. Joan Robinson. Two types of special cases of average and marginal revenue are explained below.
Rectangular Hyperbola Revenue Curves
In the case of the AR curve, which is in the shape of a rectangular hyperbola, throughout its length, if the
elasticity is equal to one, then the marginal revenue will be zero, and will coincide with the X-axis as in
Figure 10.9

Fig. 10.9 Rectangular Hyperbola

nd=1 and MR=0

DEMAND CURVE
(RECTANGULST HYPRTBOLA)

AR CURVE
Marginal Revenue curve
X

Suppose, ŋd = 1

MR = AR (1-I/ŋd)

MR = AR(l-l/l) = AR (0)/1 = 0
Revenue Curves in Oligopoly
Oligopoly means that a few sellers or producers sell a commodity in the market. In oligopoly, the demand
curve or AR curve and MR curve will not be smooth curves. They will have kinks. As the number of
sellers and the markets are small, if a firm reduces the price for its product, the other oligopolies will also
reduce the price. As a result, the firm reducing the price will only experience a relatively small increase in
sales.

106
In the Figure 10.10, we observe that there is a kink in the demand. This is associated with a vertical jump
EF in the marginal revenue curve MR. It is discrete at the point of the kink. There are two linear branches
in the demand curve. They are RT, and ill, which is steep. We have to draw the MR curve corresponding
to the RT demand curve. This is RE in Figure 10.10. Next, draw the AMR curve for the second part of the
demand curve ill. This is FMR. EF is the vertical displacement in the marginal revenue curve MR.
If the firm in Figure 10.10 wants to sell more by reducing its price P, all the other firms will follow by
matching the price cut, so that the firm will earn only a relatively small increase in sales.

Fix. 10.10 Elasticity of Demand, MR and AR in Oligopoly

In the region below the initial price P or T, the demand curve D will be steep. There is a kink at point T.
The AR and MR curves are important tools in economic analysis. AR is the demand of the firm in
question. The AR curve indicates the price line for the producer in all market conditions. The relationship
of the AR and AC curves reveals whether the firm reaps normal or abnormal profits or incurs losses. If
AC lies below the AR curve, the firm earns more than normal profits. If the AR curve is tangent to the
AC curve at the point of equilibrium, it yields normal profits.
We can also judge whether the firm is utilizing its capacity or not by taking into consideration the
relationship between AR and AC. If AR curve is tangential to the AC curve at its minimum in the
equilibrium condition, the firm is running at its full capacity. The equality of MR and MC determines the
equilibrium position of the firm under all market situations. This will show the profit maximizing output.

10.8 SUMMARY

As explained earlier in this unit, in the introduction, equilibrium of a firm is determined on the basis of
revenue and cost. This unit has touched upon different concepts pertaining to revenue. The shapes of
different revenue curves in different markets are also explained. Here you should not forget that the
shapes of total revenue curve, average revenue curve, and marginal revenue curve in perfect competition
differ from those of monopoly.
107
10.9 ANSWERS TO CHECK YOUR PROGRESS

I Revenue is the total of money received by selling certain quantity of output at a fixed price
Revenue= Quantity sold x price
II Average revenue is nothing but the price of a unit. It can be derived by the firm’s total revenue
divided by the number of units sold.

10.10. MODEL EXAMINATION QUESTION

1. What is revenue?
2. Explain marginal revenue.
3. What is average revenue?
4. Explain the relationship between AR and MR
5. Show the shape of marginal and average revenue curves in perfect competition

10.11 REFERENCES

 Varian. R Hall (1999) Intermediate Microeconomics

 Koutseyianniss A (1985) Modem Microeconomics.
 Gonld and Furguson (1985) Microeconomic Theory.
 Jhingan, M.L (1998) Microeconomic Theory.
 Barthwal. R.R (1992) Microeconomic Theory.

108
UNIT 11: EQUILIBRIUM OF THE FIRM

Contents
11.0 Aims and Objectives
11.1 Introduction
11.2 The Concept of the Firm
11.3 Objectives of the Firm
11.3.1 Full Cost Pricing
11.3.2 Satisfactory Level of Profiles
11.3.3 Maximization of Sales
11.3.4 Managerial Utility Function
11.3.5 Rate of Growth
11.4 Equilibrium of the firm
11.5 A representative Firm to Show Shutdown Point
11.6 Summary
11.7 Answers to Check Your Progress Exercises
11.8 Model Examination Questions
11.9 References

11.0 AIMS AND OBJECTIVES

This unit discusses the concept of firm, objectives of firm, and the equilibrium of the firm
After reading this unit, you will be able to
 explain the meaning of firm
 list the objectives of firm, and
 Explain the equilibrium of firm

11.1 INTRODUCTION

The term "firm” refers to a unit of control. It controls productive operations by hiring the services of
factors of production. It sells services to other firms.
A firm may have a variety of business undertakings. The firm takes decisions to produce any commodity.
It also designs the nature and quality of the product. It plans to adopt the method of producing the
commodity.
Taking into consideration the capacity required and the conditions in the market, the firm has to decide
the quantity of goods to be produced.

106
Finally, it has to frame selling costs and pricing policies. The purpose behind all these decisions is to
maximize profits.

11.2 THE CONCEPT OF FIRM

A firm is that which mobilizes resources such as raw materials. Labor, etc. to produce goods and services.
It sells goods and services to individuals and to other firms. The firm is an individual organizing unit of
control of business activity. Considering the legal commitment, the firm may be an individual one, which
is owned and controlled by a single person or it may be a partnership firm, owned and controlled by a
group of persons, or a corporation, or a co-operative firm. According to different economists, to run a
business concern or to start to continue productive activity, the owners of the firm must own some capital
goods and other materials required for it. According to Karl Marxist writers, ownership of capital is an
important pre-condition for controlling production.

11.3 OBJECTIVES OF FIRMS

The operation of firms has various goals. Different economists have explained these at length. We shall
briefly discuss some of the important objectives of firms.
It has traditionally been known that the maximization of profits is the main objective of firms. In classical
political economy, an entrepreneur or owner of firm is said to be organizing a productive activity for the
sole goal of maximizing profits. However, maximization of profits is not the only objective of the
business firms. Full cost pricing, satisfactory levels of profits, maximization of sales, marginal utility
function, and rate of growth are some of the other goals of firms

11.3.1 Full Cost Pricing

Some economists have challenged the maximization of profits by firms. According to a group of Oxford
economists of the last 1930s, prices are fixed by calculating the average direct cost per unit of output. A
reasonable percentage for overhead costs is added to the average direct cost and the price is then fixed.
The firm sells any amount of goods at this price. This procedure is known as 'full cost' pricing. It is not
however the same as profit- maximization in a given short-period situation, in which the firms do not
make maximum, profits by taking into consideration the calculation of increments of revenues and costs
on the margin of production firms coordinate their policies on the basis of full-cost pricing. In the long
run, it may have some role in determining profit-maximization

107
11.3.2 Satisfactory Level of Profits
The objective of the firm is not only profit maximization, but also to earn a satisfactory level of profits.
According to H.A. Simon, firms aim at gaining a certain level of satisfactory profits in a world in which it
is not possible to achieve maximum profits. Due to the effects of uncertainty and the lack of full
knowledge on the part of consumers regarding the firms' behavior, firms aim at satisfactory profits instead
of maximization of profits.

11.3.3 Maximization of Sales

In large firms, management is separated from ownership. The management pursues policies in their
interest rather than in the interest of shareholders. According to Prof. W.J. Baumol, the management tend
to increasing the size of the organization, which maximizes sales restricted to minimum profitable size as
long as they get the minimum level of profits. The profits are enough to create internal funds and attract
external funds for operating the firm successfully, so that the management can be saved from the
dissatisfaction of the shareholders.

11.3.4 Managerial Utility Function

As assumed by G.E. Williamson, in the corporation in which ownership is separated. the management
would like to operate the firm in such a manner that they would be permitted to spend lavishly on office
decoration, costly tours and conspicuous consumption at the dinners. Such types of expenditure are not
strictly necessary for the running of a business firm. But they take care to secure more than the minimum
profits so as to pay attractive dividends to the shareholders. More than the minimum, profits prevent a
take-over by another competing and efficient group.

11.3.5 Rate of Growth

Firms also aim at increasing production rather than an aximixing profit. According to R.L. Mareis, the
management in corporation take an interest in increasing the rate of output to meet higher demand instead
of increasing the price to respond to favorable demand conditions.

Exercise -1
1. What is a firm?
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
2. What are the objectives of a firm?
_____________________________________________________________________________________
_____________________________________________________________________________________

108
11.4 EQUILIBRIUM OF THE FIRM

When a firm starts producing a commodity, it continues production of it till it receives maximum profits.
From this level of output, if the firm either expands or contracts its output, it will earn less than maximum
profits. Suppose a firm produces commodity X, it continues the production of X commodity till it reaches
a certain level of output, say, 100 units of X. At this level of output, the firm secures maximum profits. If
the firm increases its production beyond 100 units of output of X, the profits will not be at the maximum.
If it contracts its output below 100 units of X, the profits will again be reduced. In either of the above two
levels of output, the firm will not earn maximum profits. The firm would, therefore not like to change the
production from 100 units of output of X. Thus the firm is said to be in equilibrium, where it has no
tendency either to increase or to decrease the production when it earns maximum profits.

Assumptions
To explain a firm's equilibrium position, we must assume the following:
1. The entrepreneur is rational and wants to maximize profits,
2. The firm produces only one product.

Total Cost-Total Revenue Criteria

We can discuss the equilibrium of the firm from two points of view. One is the 'total cost and the total
revenue' approach. This device is known as the Break-Even chart. The Break-Even chart is used for
determining the level of output where profits are maximum. Every firm wants to gain more returns on the
investments it makes. If the firm intends to earn huge profits, the difference between the total revenue and
the total cost must be the maximum. Table-I gives the different costs and revenues of the firm under
perfect competition. Total fixed costs remain constant, i.e., Br. 20/. The total costs are shown on the total
cost curve in Figure 11.1. In the table, the price is Br. 20/ per unit and it is fixed for the firm's output. In
perfect competition, it can sell any or all of its output at the given market price. The total receipts
(revenues) are shown on the straight line marked TR (total revenue) curve. The last column, of Table-I,
shows the profit or the loss.

109
Table-l.. Imaginary Schedule of Different Cost and Revenues

No. of Total Total Total Marginal Average Total Marginal Profit

Output Fixed Variable Cost Cost Revenue(AR) Revenue(TR) Revenue or Loss
Cost Cost (TC) (MC) (MR)
(1) (2) (3) (4) (5) (6) (7) (8) (9)
1 20 6 26 - 10 10 10 -16
2 20 12 32 6 10 20 10 -12
3 20 17 37 5 10 30 10 -7
4 20 20 40 3 10 40 10 0
5 20 24 44 4 10 50 10 +6
6 20 29 49 5 10 60 10 +10
7 20 39 59 10 10 70 10 +11
8 20 50 70 11 10 80 10 +10
9 20 70 90 20 10 90 10 0
10 20 92 112 22 10 100 10 -12
We can observe from Table-l and from Figure 11.1 that the entrepreneur earns maximum profits where
the difference between total cost and total revenue is maximum. The firm be in equilibrium when it
produces 7 units of output. At this level of output the distance between TR and TC is at the maximum and
thus profits are maximized. If it produces a few units less than 4 units, the total costs exceed the total
receipts. Because, the fixed costs are not distributed over a large number of units to bring the cost unit
below the selling price. But if the firm produces more, the losses come down, a break-even point is
reached (at 4 units of output). At this level of output, total revenue is just equal to total cost (Hr. 40/-).
This is shown in Figure 11.1 at point A, where the total cost curve and the total revenue curve conclude.
If the firm produces more and more goods, the total revenue exceeds the total costs resulting in profit.
The profits increase with greater output. Having reached the maximum capacity of the plant, if it increase
its production beyond seven units, the profits will decline again. Costs then rise on the selling price, until
profits reduce to zero. In Figure 11.1, if the firm produces 9 units of output, the profits will be zero at
point B. If the firm produces beyond this point,

110
B, it will incur losses. Thus the firm will tend to increase its output to that point (i.e.. 7 units) at which it
earns maximum profits.

1 2 3 4 5 6 7 8 9 10
OUTPUT

Fig. 11.1 Equilibrium of Firm: From the point of view of Total Cost and Total Revenue
We have to construct a tangent to TC at 7 units of output, which is parallel to the TR curve. Thus, the
slope of the TR and TC curves at 7 units, of output is equal. The slope of the total cost curve indicates
marginal cost (MC). The slope of the TR curve is called the MR curve. At the output 7 units. MR=MC.
When MR = MC, the profits will be maximum.

Marginal Cost-Marginal Revenue Approach

We can analyze the equilibrium of the firm in terms of marginal revenue and marginal cost. The firm
earns maximum profits only at the output 7 units at which MR = MC. If we look at Table-1, we see that
the firm gets maximum profits at 7 units of output, where

MR = MC = Br. 201-. If we produce more than 7 units, MC exceeds MR and the firm incurs a loss on
each extra unit produced. Loss means that the total profits decrease.

111
Fig. 11.2: Equilibrium of Firm: Marginal Cost and Marginal Revenue Curves
It is shown in the figure 11.1 that at 7 units of output that the difference between TC and TR is maximum
where profits are maximized. This is also shown in Figure 13.2 in which the MC curve cuts the MR curve
from below at the same level of output (7 units). The MR is equal to AR in perfect competition, which is
horizontal to the X-axis. In this competition, an individual firm cannot influence the market price. The
firm can sell any or all of its output at the ruling price. That is why the price for the output is fixed. It is
clear from Figure 13.2 that when the output is slightly less than 7 units, MR is greater than MC. Thus, the
producer increases profits by expanding the output. If the producer increases the output slightly more than
7 units, the MC is greater than the MR. Thus, the firm faces a decline in total profits if the output is
increased beyond 7 units. The profits are maximized only when MR = MC.
Conditions for Equilibrium
Two conditions are necessary for a firm to remain in equilibrium. These are
1) MC=MR
2) The MC curve must cut the MR curve from below the point at which profits are maximized.

11.5 A REPRESENTATIVE FIRM TO SHOW SHUTDOWN POINT

In the Figure 11.3, SRMC is the short-run marginal cost curve; SARC is the short-run average cost curve,
which is the total of the average fixed cost and the average variable cost. SRA VC is the short-run
average variable cost curve. In perfect competition, a single firm cannot control price in the market. It has
to sell its output at the ruling price. In the short run, the firm changes its production by changing variable
costs; fixed costs, however, remain constant. In perfect competition, price or average revenue is equal to
marginal revenue. This average revenue curve is also a demand curve. Therefore ,
Price=MR=AR=D

112
Fig. 11.3: A Representative Firm Showing Shut Down
Point N = Shut Down Price; R = Normal Profits
In the Figure 11.3, at ruling price OPt, the firm intends to produce OM quantity. At O:M:
output, SRMC = MR where profits are maximized.. Thus, there is a pure profit of SP per unit and total
pure profits are the area of rectangle SP 1EF (Profit per unit x Quantity = SP 1 x SF (OM). These are
abnormal profits earned at the level of output OM. In figure 11.3 at output OM, SRMC = MR 1 = P1
(AR1 )0 SRAVC > SRA VC.
If the market price falls to P 2, the firm is in equilibrium at point R at the output OM 1, where MR2 = AR2
= SRMC. At OM1 average cost is equal to average revenue so the firm is making only normal profits. The
point R is called the point of normal profits. If the price falls to P 3 where MR3 = AR3 = D3, when price is
P3, SRMC cuts 1vIR2 from below at point C at which the firm is in equilibrium. Here, the firm no longer
covers the entire fixed costs of production. If it shuts down, it would have to bear the fixed costs "from
the pocket", I\t the output OM2, the average variable cost is M 2D. At this price, OP3 the total revenue is
OP3 X OM2 = the area of rectangle OP 3CM2, which is greater than the total variable cost of the area of the
rectangle OTGM2 [OT (A VC) X OM2 (output)]. Here, the firm is covering its variable cost plus some of
its fixed costs, and so it is better off operating than if it were shut down.
If price still falls to P 4 (= MR4 = AR4 = D4), the firm is in equilibrium at point N, where MR 4 = SRMC or
MR4 = MC, here the firm is covering only its variable costs but not any of its fixed costs. The firm does
not know whether to operate or close down at this output OM3. Output OM3 is the shut down point,
where the marginal revenue is equal to the marginal cost and the average variable cost -MR = MC = A
VC. If the price is reduced further below P4, the firm will shut down because it will incur a loss by
operating production at that price.
Let us examine the profit maximizing criteria. In short run, MC must cut MR from below (where MC =
MR), while the marginal cost is rising. The formula is MC = MR = Price. This is true only in the purely
competitive situation.

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The marginal cost curve is the short run curve for the purely competitive firm. The curve indicates the
quantity the firm is willing to supply at various prices. This is why the average variable cost is of
considerable importance in the short run.

11.6 SUMMARY

We have discussed the concept of firm and the approaches of equilibrium of a firm. A firm which is an
individual organizing unit of control of business activity, has a basic objective of maximizing profits.

11.7 ANSWERS TO CHECK YOUR PROGRESS EXERCISES

1. A firm is an organizing unit of control of a business activity.

2. The following are the functions of a firm.
I) Maximizing profit
ll) Full cost pricing
Ill) Satisfactory levels of profits
IV) Maximization of sales
V) Managerial utility function
VI) Rate of growth

11.8 MODEL EXAMINATION QUESTIONS

a. What is a firm?
b. Explain the objectives of a firm.
c. What are the conditions for a firm to be in equilibrium?

11.9 REFERENCES

 Varian. R Hall (1999) Intennediate Microeconomics

 Koutseyianniss A (1985) Modern Microeconomics.
 Gonld and Furguson (1985) Microeconomic Theory
 Jhingan, M.L (1998) Microeconornic Theory
 Barthwal, RR (1992) Microeconomic Theory.

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UNIT 12: THE MARKET AND PRICE DETERMINATION

Contents
12.0 Aims and Objectives
12.1 Introduction
12.2 Elements of Market
12.3 Classification of Market
12.4 Equilibrium Price
12.5 Effects of Changes in Demand and Supply on Equilibrium
12.6 Importance of Time Element in Price Theory
12.7 Price Determination in the Market Period
12.8 Price Determination in Short Period
12.9 Price Determination in Long Period Exercises
12.10 Market Price and Normal Price
12.11 Summary
12.12 Answers to Check your Progress
12.13 Model Examination Questions
12.14 References

12.0 AIMS AND OBJECTIVE

This unit aims at explaining the meaning, elements, forms of market, and price determination under short
and long periods.
After reading this unit, you will be able to
 explain the classification of markets
 understand the price determination
 distinguish between market price and normal price
 define market, and
 list the elements of market

12.1 INTRODUCTION

The term 'market' is an elusive concept. The word is generally used to describe the process of exchange
always and it involves certain elements such as goods or services, buyers, place and time.

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"Originally" says Jevons, "a market was public place in a town where provisions and other objects were
exposed for sale; but the word has been generalized so as to mean any body or persons who are in
intimate business relations and carry on extensive transactions in any commodity. A great city may
contain as many markets as there are important branches of trade and these markets may or may not be
localized. But the idea of locality is not necessary, the traders may be shared over a whole town, or
region, or a country and yet form a market, if they are by means of fairs, meetings, and published price
lists, the post office or otherwise in close communication with each other", .

According to Cournot, a French economist, “economics understands by the term market not any particular
market place in which things are bought and sold but the whole of any region in which buyers and sellers
are in such free interaction with one another that the price of the same goods tends to equality easily and
quickly"
Some elements of markets are (l) there must be a commodity which is to be dealt with; (2) there must be
buyers and sellers; (3) there must be a place, be it a certain province, a country to the entire world, where
the process of exchange takes place; (4) there must be interaction between buyers and sellers. For
example, in a vegetable market, the buyers and sellers usually meet and an exchange takes place between
them. But in a share market, or foreign exchange market, the buyers and sellers may not see each other
face to face, and transactions still take place through different modes of communication. Thus, there are
certain goods, which are marketed locally, but there are certain articles like shares and foreign exchanges
that can be and their domain of operation may be spread throughout the world. These goods have an
international market.

Exercises -1
1. What is a market?

_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
2. List the elements of a market
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________

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12.3 CLASSIFICATION OF MARKETS

We may classify a market into three categories according to factors such as area, time and nature of
competition.

On the Basis of Area

(a) Local Markets- such as weekly fairs in villages and daily consumer goods in towns:
(b) National Markets-dealing with articles which have demand through like radios, medicines and
television sets:
(c.) International Markets-There are certain commodities the transaction of which is carried on throughout
the world. For example, jute goods etc.
On the Basis of time
a) Very short period market
b) Short period market
c) Long period or secular markets, which cover a generation.

On the Basis of Nature of Competition

On the basis of nature of competition, markets are classified into two viz perfect and imperfect
competitions. We shall discuss them briefly here. They will be dealt with in detail later.
a) Perfect Competition: There are huge numbers of buyers and sellers in the market. Buyers and sellers
are aware of the prices at which transactions take place. For a commodity, the same price prevails
uniformly throughout the market. No individual seller or buyer can influence the price in the market. The
market for perishable goods like vegetables, eggs etc,. to a certain extent resembles this type of
competition
b) Imperfect Competition: There are huge numbers of buyers and sellers but fewer than the number of
buyers and sellers in perfect competition. The buyers and sellers are not aware of the offers made by
others. Naturally, the same price cannot prevail for the same commodity at the same time in imperfect
competition. Goods are not homogeneous and are not perfect substitutes. That is why the price will not
prevail throughout the market.

12.4 EQAILIBRIUM

The buyers and sellers in the market bargain about goods and services. They agree to purchase and sell-
goods and services at a certain price. In this manner, the price is determined by the interaction of buyers
and sellers. In other words, demand and supply determine prices.

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Buyers in the market follow the law of demand. The Law of demand reveals that when the price falls the
demand increases and when the price rises the demand decreases. The sellers follow the law of supply.
According to this law, when the price rises the supply is increased and when the price falls the supply is
decreased. Thus, demand and supply move in opposite directions. Price is determined by the interaction
of demand and supply and the price at which demand and supply are equal is known as the equilibrium
price.
Equilibrium quantity is the quantity supplied and the quantity demanded at equilibrium price. If the price
is more or 1ess than the equilibrium price, the equilibrium output is disturbed. But ultimately the quantity
demanded and the quantity supplied will be balanced at some equilibrium price.
We can explain this process of reciprocity with the help of schedule and figure. In Table-l, the quantity
demanded and supplied is shown.
Table-I: Quantity Demanded and Supplied (in kgs)

Price Birrs Quantity Supplied

2 200 50
3 150 75
4 130 100
Equilibrium price 5 110 110 Equilibrium quantity
6 90 120
7 80 130

When the price of mangoes is Birr. 2/ per Kg,. the demand for the~ is 200 kgs, but the quantity supplied is
50 Kg. If the price rises to Birr 3/- the supply increases to 75 Kgs, whereas the demand falls to 150. If the
price is again raised, the supply will increase to 100, and the demand will be further reduced to l30Kg.
Again, when the price goes up to Birr. 51-per Kg. The quantity demanded or supplied is 110 Kg. At a
price of Birr .5/-per Kg, the buyers are ready to purchase 110 Kgs and the sellers are ready to offer
110Kgs. This is the equilibrium price, and then quantity supplied at this price is called the equilibrium
quantity, i.e., 110 Kgs. Once the equilibrium price is determined, there is no tendency change from this
price as this satisfies both the consumers and the producers. If, at any time, the price is more or less than
Birr.5/- the forces of demand and supply will '- adjust it back to Birr.5/-. For instance, if the price
increases to Birr. 6/- the quantity demanded is decreased, but the quantity supplied is increased. At
Birr.6/, the demand will be 90 Kgs and the supply will be l20Kgs. When the supply is greater than the
demand, the seller has to reduce the price to Birr .5/-As a result, the supply will fall to 110 Kg, and
demand will also increase to 110 Kgs, Thus, the .equilibrium price is re-established. On the contrary, if
the price decreases to Birr. 4/- the demand will increase to 130 Kgs. The supply will fall to 100Kgs.

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Here, then supply is less than demand. Decreased supply and an increased demand will lead to a rise in
the price to Birr.5/-, where the demand and supply will be in equilibrium. In this manner, the equilibrium
is maintained again.

In Figure- 12.1, DD is the demand curve and SS is the supply curve. These two curves intersect at point
E. The point at which demand is in equilibrium quantity, is called the equilibrium point. OP is the
equilibrium price at which OM, the equilibrium quantity is demanded and supplied. If demand is less than
supply, every seller will try to sell his quantity of the product first by reducing the price a little. Sellers
compete among themselves to bring down the price to the equilibrium level. Thus, demand and supply
determine the equilibrium price. Once it is established, any disturbance from this equilibrium level will be
restored by the forces of demand and supply.

Fig. 12.1 Equilibrium price

12.5 EFFECTS OF CHANGES IN DEMAND AND SUPPLY ON EQUILBRIUM

PRICE

Changes in demand and supply bring about changes in the equilibrium price level and the equilibrium
quantity. When there is a change in either the demand or the supply or both, a new equilibrium price is
established. Thus, whenever change in either demand or supply takes place, a new equilibrium price is
determined.

Effects of Changes in Demand

There are some conditions, which bring about changes in demand. A change in incomes, tastes, prices of
substitute goods and preferences of consumers will lead to a change in demand. Figure-12.2 shows the
effects- of a change in demand and the resultant equilibrium price and quantity. DD is the demand curve
and SS is the supply curve. The supply curve remains the same.

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Fig. 12.2 Equilibrium price: Effects of Changes in Demand
The DD and SS curves intersect at point E and the quality demanded and supplied is OM at OP
equilibrium price. Given the supply, if the demand increases the demand curve shifts upward to the right.
Due to a change in demand, the demand curve DIDl intersects SS supply curve at point El. The equilibrium
price is increased from OP to OP 1 and the equilibrium quantity from OM to OM. On the other hand, if
demand falls, the demand curve shifts downwards to the left. Due to a change in demand, the curve D 2D2
intersects the supply curve SS at point E2. The equilibrium price is OP 2 which has decreased from Op to
OP2 and the equilibrium quantity from OM to OM 2. Supply being given, a decrease in demand reduces
both the price and the quantity and vice versa.

Effects of Changes in supply

Changes in supply are brought by changes in technical knowledge and factor prices. Fig12.2 explains the
effects of changes in supply. Demand being given, the supply curve is SS

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 X
Quantity M2 M M1

Fig.12.3 Equilibrium price: Effects of Changes in Supply

Demand curve is DD.SS and DD intersect at point E, where supply and demand are equal at OM quantity
at OP equilibrium price. Given the demand, if the supply increases, the supply curve shifts to the
rightS1S2.The new supply curve, which intersects DD curve at E1 at E1, reduces the equilibrium price
from OP to OP1 and increases the equilibrium quantity from OM to OM1. On the contrary, when the
supply falls, the supply curve moves to the left (S2, S2) and cuts the DD curve at point E2 at which the
equilibrium price is raised from OP to OP2 reducing the equilibrium quantity from OM to OM2.

Effects of Combined Changes in Demand and Supply

Now, we shall study the effects of combined increases and l or decreases in demand and supply.
When both demand and supply increase, the quantity of the product will increase definitely. But it is not
certain whether the price will rise or fall. If an increase in demand is more than an increase in supply, then
the price goes up. On the other hand, if an increase in supply is more than an increase in demand, the
price falls but the quantity increases. If the increase in demand and supply is same, then the price remains
the same.
When demand and supply decline, the quantity decreases. But the change in price will depend upon the
relative fall in demand and supply. When the fall in demand is more than the fall in supply, the price
decreases. On the other hand, when the fall in supply is more than the fall in demand, the price rises. If
both demand and supply decline in the same ratio, there is no change in the equilibrium price, but the
quantity decreases.

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If the increase in demand is greater than the decrease in supply the price rises. If decrease in supply, is
greater than in demand, then also the price increases. If the increase in demand is exactly equal to the
decrease in supply, then the price rises, but the equilibrium quantity remains the same.
Thus, the price is determined at the point where both demand and supply cut each other. The only really
accurate answer to the question whether it is supply or demand, which determines price, is that it is in fact
both. At times it will seem that one is more important than the other, for one will be active and the other
passive. For example, if demand remains constant but supply conditions vary, it is demand, which is
passive and supply, active. But neither is more or less important than the other determining price.

12.6 IMPORTANCE OF TIME ELEMENT IN PRICE THEORY

The forces of demand and supply determine price. The influence of time on the determination of price
was first recognized by Marshal. When the demand for a commodity changes, its supply will also change.
But the changes in demand and supply will not be possible at the same time. For example, an increase in
demand will possible .Only after some time. The supply will take time to adjust itself to a change in
demand. Moreover, supply is based on costs of production, which change over time in the short period. It
is not possible to change the size of a firm as costs of production are high. In the long-run, there is enough
time to change the size of the firm to any extent as it should be able to produce at a lower cost. Hence, the
element of time is very important in the determination of the price of a commodity. Marshall indicates
that there are four periods in the theory of value. (1) The market Period or Very Short Period, (2) The
Short Period, (3) The Long Period, and (4) The Very Long Period or the Secular Period. Here we shall
discuss only the first three types. Marshall classified the periods in terms of operations, or in terms of the
period required for economic forces to work. Market period is one in which there is no time to change the
supply of the product. The short period refers to a period in which the supply can be changed to some
extent without changing the size of the firm. The long period is that which is long enough to adjust the
supply even by altering the size of the plant to meet changes in demand.

12.7 PRICE DETERMINATION IN THE MARKT ERIOD

Market period is a very short period in which the production is neither decreased nor increased. In other
words, the supply of the product remains fixed. Here, the nature of commodity plays its role in the
determination of price. Certain commodities are perishable in nature. These include fish, vegetables,
flowers, and cannot last long or cannot stay fresh for more than a few days, or for some time in a day.
That is why they must be sold within a short period; say a day (market time). Otherwise, they will
deteriorate; there will be no demand for them after a particular time is over. In the above case, the supply
curve of the goods is a vertical line as depicted in Fig-12.4.

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Fig 12.4 Market period price determination: Perishable Goods
The vertical supply curve reveals that the supply of goods, which are to be sold in the market at any price,
is fixed. While there is no change in the supply, there may be changes in demand in the market period In
this situation, demand determines the price. If demand is more in the market, a higher price will prevail
and vice versa. MPS is the market period supply curve, which is fixed. DD is the demand curve. DD
intersects the MPS curve at point E, and OP is the equilibrium price. If demand increases, supply being
constant, the price increase. D1D1 is the increased demand curve which cuts MPS at point EI. The
equilibrium price increases from OP to OP which is higher than the initial price. This shows that supply
being fixed, demand has full influence on the determination of the price of the product.
Non-perishable goods, unlike perishable goods, can be stored. Such goods will have a reservation price,
below which the producer will not like to sell them. The cost of production of a commodity influences the
reservation price. In the market period all costs are fixed costs and they do not influence prices. In the
market period, supply is fixed and changes in demand exert an influence on the determination of price.
But according to Marshall, even in the market period in the case of durable goods, both supply and
demand are equally required for the determination of price. The firm will sell no commodity below its
reservation price. This is shown in Fig-12.5. The market period supply curve is MPS for durable goods.
This curve indicates that nothing can be sold below the reservation price OS.

DD is the demand curve, which

interacts with MPS at

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point E. The market price is OP at which the whole production is supplied. Below this price OP, or from
the reservation price OS, as demand increases supply is also increased up to OP, the market price. In the
market period, if demand increases further, the supply remains fixed at OM level but the price rises- D IDI
is the changed demand curve, which intersects the vertical part of MPS curve at point EI where price
increases from OP to OP1. This will occur in the case of durables and semi-durables.

12.8 PRICE DETERMINATION IN THE SHORT PERIOD: SHORT-RUN N

PRICE

Short-run is the period in which a firm varies its output by changing variable factors, while fixed factors
remain constant. In the short-run period, if a firm wants to increase or decrease its production, it will
employ more labor, raw materials, etc., or less labor, raw materials etc., to match the increase or decrease
in demand. But fixed factors or the size of the plant remain same.
In the short-run, the forces of supply and demand determine the price. The supply curve will rise upwards
from left to right. The price at which the demand and supply curves intersect each other is known as the
short-run equilibrium price. The short-run price is also called the short-run normal price. It is illustrated in
Fig. 12-6.

MPS is the market period supply curve and DD is the demand curve, which intersects MPS at E, and OP
price and OM quantity are established. If the demand for the period rises, this is shown by the demand
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curve D1D1. In the market period, the supply is fixed and it is not possible to increase the production
beyond OM. That is why, the market price will immediately be increased from OP to OP 2. But in the
short period, it is possible to increase the production with the help of existing plant capacity, by
employing more labor, raw materials, etc. Thus, the supply will be increased along the SRS (short run
supply) by increasing the variable capital. D 1D1 is a new demand curve. The SRS curve intersects
D1D1.The short-run normal price is OP 1 at equilibrium quantity OM1 This price OPI is higher than the
original market price (OP), but it is lower than the market price OP2 after increased demand.

12.9 PRICE DETERMINATION IN THE LONG PERIOD: LONG-RUN NORMAL

PRICE

Long-run is such a long period that in it production may be changed by varying the fixed as well as the
variable factors. In the long period, supply fully adjusts itself to the changes in demand. The long period
demand and long period supply of the industry determine the normal price of a product.
In the long period, there is sufficient time for new firms to enter the industry and for old firms to leave the
industry. When the firms in the industry are earning more than normal profits, new firms enter the
industry so that production increases and brings the price down to the original normal price. When firms
in the industry are incurring losses, some old firms leave the industry, due to which production decreases.
This results in raising the price to the original normal price.

The long run new price may be equal to or less or more than the initial price. It depends on the laws of
returns of the industry. If the industry is operating under increasing cost conditions or diminishing returns,
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the normal price is higher than the original price. If it is operating under decreasing cost conditions or
increasing returns, the normal price is lower than the original price. If it is operating under constant cost
conditions or constant returns, the normal price is equal to the original price. Thus, there is no change in
normal price in constant returns.
We shall discuss below the long period normal price under various cost conditions.
Long-Run Normal Price in Increasing Cost Industry
If the industry is operating under increasing cost conditions the long-run supply curve of the industry will
rise upwards to the right as production increases.

In Fig.12- 7, LRS is the long -run supply curve. SRS is the short-run supply curve and MPS is the market
period supply curve. DD is the industry demand curve which intersects LRS, SRS, and MPS at E. At this
point ,the industry is supplying OM output at OP equilibrium price. If the demand curve shifts upwards
from DD to D1D1 in the short period, due to the increase in demand, the industry increases its supply to
OM2 level of output by increasing only the variable factors at OP, price. But in the long-run, the industry
can adjust the supply to the increase in demand by changing the fixed as well as the variable factors of the
firm. In the long-run, new firms will also enter the industry. The industry will increase its supply to OM 1
which is more than the increase in supply in the short-run. The new equilibrium price OP 1 is established
where DIDI intersects LRS at E at which equilibrium output is OM1. The long-run equilibrium price Op1 is
more than the initial price OP. But the long run equilibrium price OP 1 at output OM, is less than the short-
run equilibrium price OP2 at OM2 output and market price OP3 at OM output.

Long-Run Normal Price in Constant Cost Industry

If the industry is operating under constant cost conditions, the long-run supply curve of the industry is
horizontal to the OX-axis illustrated in Figure 12-8 by the LRS straight line. DD is the industry demand
curve, which cuts LRS, SRS, and MPS at point E. The equilibrium price is OP at OM equilibrium output.
If the demand curve shifts to D 1D1 the supply is increased to OM 2. Due to increase in demand in the short-
run the equilibrium price is increased from Op to OP I. In the long- run there is sufficient time to increase
the scale of the plant. The long-term industry demand curve D 1D1 intersects LRS at El, where the
equilibrium output is OMI at OP equilibrium price. LRS is horizontal to the OX-axis. This shows that
under constant cost conditions, the long- period normal price is the same as the initial price whether the
output increases or decreases. Thus, it remains at the same level as it was in the short run.

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Long-Run Normal Price in Decreasing Cost Industry
If the industry is operating under decreasing cost conditions, the supply curve in the long-run will slope
downwards. In the long-run, as the industry expands it will enjoy the advantage of external economies,
which lead to firms’ cost curves shifting downwards. While in the short run the price will increase as a
result of increase demand, in the long run price is less than the initial price.

In Figure -12.9, DD is the original demand curve, which cuts MPS, SRS, and LRS at E. At this point, the
equilibrium price is OP1 and the output bought and sold is OM. If the demand curve shifts to the right, it
intersects LRS at EI in the long run. In the long run, as demand increases, the equilibrium price OP, is less
127
than the original price OP which is the result of increasing returns to scale. But the output bought and sold
is increased, from OM to OMI. In the short period, as demand is increased, the supply is also increased
but less than the increase in supply in the long run. That is why the price is higher than the original price
in the short run.

In the long period, it is obvious that the normal price is higher, lower, or the same as compared with that
of the initial market price. This depends on the cost conditions of the industry in question. It also depends
on internal economies or dis-economies and external economies or dis-economies, However, in the short-
run, the normal price will invariably be higher than the long-run normal price.

12.10 COMPARISON OF MARKET PRICE AND NORMAL PRICE

a) Market price prevails in a market on a single day or in very few days. It prevails at a particular time.
Normal price tends to prevail in the long run. It has a tendency to prevail over a period of time.
b) Demand is important in the determination of market price, while supply is fixed. On the other hand, the
determination of normal price depends more on the role of supply which tries to adjust itself fully to any
change in demand.
c) Market price may vary many times in a day or a week as a result of passing events and temporary
events which influence it greatly. For example, if there is a band on a particular day the price of
perishable goods may shoot up. But it is only a temporary phenomenon as the very next day they may
come to normalty again.
Market price is a temporary price. In the long-run, demand and supply may be changed by permanent
forces. The changes in demand and supply determine normal price. That is why normal price is
permanent and stable. Market price oscillates around normal price.
d) In the long-run, normal price always coincides with the long run average cost at its minimum point.
Therefore, firms gain only normal price.
e) All commodities have a market-price. The goods which are produced again and again have a normal
price. Non-supply of such goods can be increased in the long-run to adjust increases in demand. Non-
reproducible goods such as collections of rare coins and paintings etc. Cannot have a normal price, but
they gave a market price. The supply of such goods cannot be increased.
f) Normal price is not a real one, whereas market price is real. Normal price may occur when demand
equals the changes in supply in the long run. But these changes may not be same in the long run. Changes
in demand may be more or less than changes in supply. That is why, normal price is never arrived at in
the long-run. In practice, a long period normal price is never arrived at. There is usually a change in some
of the conditions underlying the long period equilibrium before it has had time to come into being. The
price which is existing in the market is always the market price rather than the normal price.
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12.11. SUMMARY

Market is explained as a process of exchange of goods or services from sellers to buyers. Every
commodity will have its own market. On the basis of area, time and nature of competition, markets are
classified. In the market, quantity demanded and quantity supplied determines the price. Equilibrium
price is achieved if demand and supply are equal. If price is changed, the changes in supply and demand
bring back the equilibrium. Changes in demand and supply affect the equilibrium price and equilibrium
quantity.

The importance of time element in price theory is explained by Prof. Marshall. He explained about four
periods: market period, short period, long period, and very long period. This unit has dealt with the first
three periods. How price is determined in the three markets is explained in the unit. In the market period,
demand affects the price. In the short-run, the forces of demand and also supply determine the price. But
supply depends on variable inputs only. Fixed capital cannot be changed in the short period. In the long-
run, there will not be any fixed capital as fixed factors can be changed.
Therefore, in the long period, supply and demand forces determine the price, where supply becomes an
active variable.

This unit has differentiated the market price from normal price. Market price prevails in the market
period, i.e., at a particular time, while normal price prevails over a period of time i.e., in the long run.
Demand affects the market price where supply is a passive variable. Supply is the major force in
determining the normal price.

12.12 ANSWERS TO CHECK YOUR PROGRESS EXERCISES

1. Market is a place where sellers and buyers meet together to carry on the transactions in any
commodity.
2. The elements of market are
i) The commodity ii) The place
iii) Sellers and buyers
iv) There must be interaction between sellers and buyers.

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12.13 MODEL EXAMINATION QUESTIONS

1. Explain the equilibrium price.

2. What is a market period?
3. Explain the price determination in the market period.
4. What is normal price?
5. What are the elements of market?

12.14 REFERENCES

 Varian. R Hall (1999) Intermediate Microeconomics.

 Koutseyianniss A (1985) Modern Microeconomics.
 Gonld and Furguson (1985) Microeconomic Theory.
 Jhingan, M.L (1998) Microeconomic Theory.
 Barthwal, R.R (1992) Microeconomic Theory.

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UNIT 13: PERFECT COMPETION

Contents
13.0 Aims and Objectives
13.1 Introduction
13.2 Perfect Competition
13.3 Characteristics of Perfect Competition
13.4 Perfect Competition Vs Pure Competition
13.5 Equilibrium of the Firm and Industry
13.6 Equilibrium in the Short-Run
13.7 Equilibrium in the Long-Run
13.8 Optimum Firm
13.9 Summary
13.10 Answers to Check Your Progress Exercises
13.11 Model Examination Questions
13.12 References

13.0 AIMS AND OBJECTIVES

This unit presents the characteristics of perfect competition and equilibrium of firms and industries.
After completing this unit, you will be able to:
 understand the features of perfect competition
 explain the assumptions
 interpret the equilibrium position.

13.1 INTRODUCTION

In unit 10 we have discussed about cost and revenue curves. We shall use these curves in discussing the
equilibrium of firms and industries. These curves show how the firm reaches equilibrium under different
conditions. In the previous unit, we studied about equilibrium in general. In this unit we shall deal with
the equilibrium of a firm or industry in the short-run and in the long-run in conditions of perfect
competition.

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13.2. PERFECT COMPETITION

In perfect competition, there are a large number of buyers and sellers. The sellers sell homogeneous
products and the buyers as well as sellers have perfect knowledge about the market. According to John
Robinson, "Perfect competition prevails when the demand for the output of each producer is perfectly
elastic. This entails first that the number of sellers is large, so that the output of the commodity, and
second, that buyers are all alike (similar) with respect to their choice between rival sellers, so that the
market is perfect."

13.3 CHARACTERISTICS OF PERFECT COMPETITION

A Huge Number of Buyers and Sellers

There must be huge number of buyers and sellers in the market. Any one seller or buyer cannot influence
the ruling price in the market. Each buyer’s demand is a negligible part of the total market demand. The
individual buyer's activity will have no control on the market price. Similarly, as there are a huge number
of firms, each firm's output forms a very small fraction of total output and cannot influence the market
price. That is why each individual buyer and producer will have to accept the ruling price. In other words,
the firm is a price taker but not a "price giver'. Hence, the demand curve for the product will be perfectly
elastic at the existing price and the demand for the quantity of the product will be as per its sale.
Homogeneous Product
In perfect competition, the product produced by all firms is identical. A commodity produced by one firm
is the same as that produced by another firm. That is why the buyers in the market are indifferent to the
firm when they go to purchase their commodities. Similarly, the producers are indifferent to the buyers to
whom they sell. The consumer feels no difference whether he buys the commodity from one firm or
another in the industry, because the commodity is identical. Hence, there is a single price for the product
in the market. In perfect competition, there is absolute elasticity of demand. In other words, the demand
curve is a straight line, horizontal to the OX -axis. The demand curve or the average revenue curve and
the shape of marginal revenue are the same. Horizontal Shape of Demand curve
In perfect competition the average revenue curve or demand curve of a firm will be a horizontal straight
line, which is parallel to the OX-axis. This type of demand curve indicates perfect elasticity of demand.
This means that any firm can sell any quantity at the existing price. As there are huge numbers of firms in
the market, market price cannot be influenced by an individual firm. Since homogeneous commodities are
produced by various firms, the price paid by the consumers cannot be different. This can be illustrated
with the help of a diagram.
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 REVENU /PRIC
p
AR=MR=PRICE

O X
QUANTITY
Fig-13.1: Shape of Demand or Average Curve of a Firm Under Perfect Competition

Price and revenue are measured on 'CY -axis. Quantity is measured along the OX-axis. At price OP the
producers sell as much as they like. Because at OP price the demand curve is perfectly elastic, the
producers offer as many goods as they can. Neither can the price be increased nor decreased. If the price
is increased the sellers lose their customers.
Three conditions are necessary for pure competition to exist. Pure competition for agricultural goods such
as teff, wheat, etc. can be found in other sectors, we rarely come across pure competition. In addition to
the three conditions mentioned above, certain other features must be required to create perfect
competition.

Free Entry and Free Exit

In perfect competition, there are numerous firms in the industry. Any firm can expand its production or a
new firm may be set up when the firms in the industry are making abnormal profits in the short-run. No
restriction is imposed on the expansion of existing firms or the installation of new firms. Producers are
also at liberty to curtail the firm's scale of production. 'Complete freedom prevails in perfect competition
for entry into an industry or exit from it. In the long- run, all the firms earn normal profits and no firm
either leaves the industry or enters in to the industry. In the circumstances, each firm operates at an
optimum output in the long-run.

Perfect Mobility of Factors of Production

Factors of production such as labor and capital have perfect mobility in perfect competition. Workers go
from one productive activity to another productive activity. Similarly, entrepreneurs move from one
industry to another industry so that they can earn more income. In this manner, each factory owner earns
its opportunity cost in a perfect competition.

Absence of Transport Cost

There are no transport costs in perfect competition. To have the same price for the same product through
out the market, it is essential that the transport costs incurred for carrying the product from one place to
another should not be added to its price. If the transport costs are added to its price, even homogeneous
products will not have the same price due to the distance from which they are transported to the market.

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Perfect Knowledge of Market Conditions
The buyers and sellers have complete information about market conditions. The buyers have perfect
knowledge about the conditions prevailing in the market for purchasing a commodity at the market price.
If they do not have perfect knowledge, they may pay a higher price for the product. Then, there would be
different prices for the same product. So the buyers and sellers must have perfect knowledge to be able to
buy goods and raw materials at the prevailing market price.

13.4 PERFECT COMPETITION VERSUS PURE COMPETITION

In perfect competition, perfect knowledge of market conditions is essential to have a single price for the
product in the entire market. According to Chamberlain, pure competition means" competition unalloyed
with monopoly elements" whereas perfect competition involves "perfection in many other respects than
the absence of monopoly only”. Nowhere in the real world, does perfect competition exist. Thus, perfect
competition is an ideal market form. Though perfect competition is an ideal condition, we have to study
the characteristics of perfect competition to understand the working of an economy.

13.5 EQUILIBRIUM OF THE FIRM AND INDUSTRY

In perfect competition, an individual firm cannot influence price. A firm is said to be in equilibrium when
it has no tendency to alter its production. The firm neither expands not contracts its level of output. The
firm earns maximum profits. Equilibrium is achieved at a point, where marginal cost coincides with
marginal revenue. We can show this diagrammatically. In perfect competition, the MR curve of a firm
coincides with the AR curve. At the given price, the demand curve is perfectly elastic. The firm can sell
as much as it wishes to sell so that the demand curve or AR curve is horizontal to the OX-axis. That is,
the MR curve is horizontal to the OX-axis or MR=AR ( price). Here, the MC curve must cut the MR
curve from below, and after the point of equilibrium it must be above the MR curve. The firm is in
equilibrium when Price= MC=MR=AR

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In the condition of equilibrium under perfect competition in Figure 15.2 above, the existing market price,
OPPD, is both the average and marginal revenue curve. The marginal cost curve which is
V-shaped is MC. The firm's output is measured on the OX- axis and the cost and revenue are measured on
the OY -axis. In perfect competition, the marginal cost curve is also its supply curve.
When there is an OP level of price in the market, the MC curve cuts the MR curve at point E from above
where MC and MR are equal, but it is not a point of maximum profits. If the firm increases its production
beyond point E, the MC is below the MR curve, the cost per additional unit decreases and the firm earns
large profits. As long as the MC curve is below the MR curve, it is desirable to increase production till it
reaches the OM level of output at the point F where MC-MR.

At point F, the MC curve cuts the MR curve from below. At this point the firm can maximize its profits.
Suppose, the firm expands its production beyond the point F, the MC curve is above the MR curve, where
the cost per additional unit is increasing and is greater than MR. Beyond the level of OM output, the firm
incurs losses. So the firm is in equilibrium at OM level of output at point F where MC =MR. price and
AR are equal under perfect competition. Two conditions are to be fulfilled to achieve the equilibrium
position of the firm. These are
1) MC=MR
2) MC curve must cut MR curve from below.
The equilibrium level of output, however, does not guarantee maximum profits. The positive profits of a
firm depend on the relation between total revenue and total costs or average revenue and average costs.

Assumptions
To explain the equilibrium of a firm in the short-run and the long-run, the following assumptions are
usually made
1. Identical cost conditions: MC and AC cost conditions are the same for all firms in the industry.
135
2. The efficiency of entrepreneurs is the same for all firms.
3. Factors of production used by various firms are homogeneous.

13.6. EQUILIBRIUM IN THE SHORT-RUN

The short-run is the period when the firm varies its production by changing variable factors, where the
fixed capital remains unchanged.
So far, we have explained equilibrium conditions to be fulfilled by a firm to achieve the equilibrium
condition. But we cannot understand a firm’s absolute profit or loss position. To understand profit or loss
position, we must consider three possibilities:
a) When a firm earns abnormal profits,
b) When a firm earns normal profits,and
c) When a firm incurs losses

When A Firm Earns Abnormal Profits

In Figure 5.3, if price is OP,PL is the average revenue and marginal revenue curve in perfect
competition. SMC is the short-run marginal cost curve and SAC is the short run average cost curve. They
are generally
U-shaped curves. The firm is in equilibrium at output OM2, where the MC curve cuts the MR curve from
below at R, i.e., MC= MR =AR. At output OM2 the average cost is M2 T and the average revenue or
price is OP or M2R. Here, the price or AR is greater than the average cost. The firm is earning M2R -M2
T profits per unit.

Total Revenue=AR x Output

= OP x OM2 = OPRM2
Total Cost = AC x Output

= OC X OM2 = OCTM2

Abnormal Profits = TR- TC = OPRM2 CTM2

= CPRT

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The firm is earning more than the normal profits. There are a number of firms in the industry earning
abnormal profits. In perfect competition, when firms with identical cost conditions are earning
supernormal profits in the industry, new firms enter the industry so as to compete and draw away the
abnormal profits. But in the short-run, it is not sufficient for new firms to enter the industry. So the
existing firms continue to earn supernormal profits though the firms are in equilibrium. The industry will
not be in equilibrium as there is a chance for new firms to enter the industry.

When A Firm Earns Normal profits

Suppose the market price is OP1, P1L1 marginal revenue curve at point E from below where the firm at
output OM is in equilibrium. The minimum SAC is tangent to the average revenue curve at point E,
where, AR = AC and MR = MC =AR =AC. At output OM, the firm earns only normal profits. All the
firms with identical cost conditions earn only normal profits, where there is no tendency to leave or enter
the industry. Here, the firm as well as industry will be in equilibrium in the short-run. This type of
equilibrium occurs by accident only. Therefore the firm neither gains abnormal profits nor incurs losses
When a Firm Incurs Losses
In the short-run, if the prevailing market price is OP 2, P2L2 is both the average and the marginal revenue
curve. The SMC curve cuts P2L2 marginal revenue curve at point S at OM 1 level of output, where the firm
is in equilibrium. Though the firm is in equilibrium, it incurs losses, the cost per unit being greater than
price. Average cost is M1F or OC1 and the average revenue is OP2 or M1S.
The firm is incurring loss. MIS- M1F = FS per unit.

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Total Cost = AC x Output
= OCI x OM I = OC1 FMI

Total Revenue = AR x Output

= OP2 x OMI = OP2 SM1

Total Loss = Total Revenue -Total Cost

= OP2 SM1- OC1 FM1

= P2 CIFS.

The firm is incurring losses in the short-run. All the firms with identical cost curves are also incurring
minimum losses. There is a tendency for the firms to leave the industry if not in equilibrium and there is a
tendency for firms to quit the industry. In the short run firm change production by varying the variable
capital. If the price is more than the average variable cost, the firm covers the full variable costs and a part
of the fixed costs, so that they remain in the industry instead of leaving. If losses are greater than the
variable costs and the fixed costs, then the firm will close down to avoid unnecessary losses.

13.7 EQUILIBRIUM IN THE LONG- RUN

Long-run is a period which is long enough to change the level of output by altering the variable capital as
well as the fixed capital. Unlike short-run, in the long-run all factors are variable, nothing remains fixed.
If production is to be increased, or decreased, the plant size will be increased or decreased according to
the demand conditions in the market. In the long-run, to meet the demand situation, the plant size or fixed
capital or plant capacity is changed, but this is not the situation in the short-run. In the long-run, the long-
run average cost and marginal cost curves are relevant in determining the equilibrium level of output. In
the short-run, a firm has to be in equilibrium when MC is equal to MR .This holds valid even in the long-
run period. In the long-run, when MC is equal to MR and the price is equal to the average cost, the firms
in the industry earn abnormal profits, Encouraged by abnormal profits new firms enter the industry, with
the result that production is increased. Competition for the extra profit force firms to enter the industry,
with the result that production is increased. Competition for the extra profit forces firms to keep the price
down to the average cost. If the price is below the average cost, the firm in the industry incurs losses. To
avoid heavy losses, some firms leave the industry. This decreases the production and forces the price to
stay at the average cost, so that the firms remaining in industry make normal profits.

138
In the long-run, a firm is said to be in equilibrium if two conditions are fulfilled:
1) Price (AR) = MC = MR
2) Price (AR) = MC = AC
Hence, in perfect competition in the long-run the firm will be in equilibrium if price = AR=MR=AC.
In the long-run, while LAC is falling, LMC is below it; while LAC is rising, the LMC is above it; if LAC
is neither rising nor falling, the LMC intersects it at its minimum, where LMC= minimum LAC= MR =
price (P). That is, when a firm is said to be in equilibrium, earning normal profits, the LMC intersects the
LAC at its minimum which is equal to price.
Price: Marginal Cost = Minimum AC. We can understand this with the help of a diagram.

In Figure 13.4 LAC is the long-run average cost curve and LMC is the long-run marginal cost curve. If
the market price is OP1, P1LI is the average and marginal revenue curve in the perfect competition. At
price OP1, the firm is in equilibrium at point R at output OMI. All the firms with identical cost curves
earn abnormal profits, with the result that new firms enter the industry and increase production. The
increase in production presses down the price to OP level and equates it to the average cost at its
minimum, where the firm and industry will be in equilibrium.

If the price is OP2, which is below AC, the firm will be in equilibrium at point T where MC= OP 2 which
is less than AC. All the firms with identical cost curves will incur losses. As a result, to avoid losses the
firm in perfect competition will leave the industry in the long-run. This reduces the level of output in the
market raising the price from OP2 to OP to equal average cost, where the firm will be making normal
profits. In such a situation, a firm will not leave or enter industry. The firm and industry are said to be in
equilibrium in the long-run. Therefore, the firm and industry get only normal profits in the long-run. LMC
139
cuts LAC at its minimum point, E, where price =AR = MR =AC =MR. In Fig. 15.4, OP is the long-run
price and OM is the long-run equilibrium quantity and the firm and industry will be in equilibrium at
point E.

13.8 OPTIMUM FIRM

An entrepreneur produces commodities with the given scale of the plant. As he increases production, the
cost per unit decreases. He continues to increase the level of output till he gets economies of scale. After a
stage, he however stops the production of the commodity when he reaches its minimum cost of
production. The average cost is the lowest at this point. If he still expands his level output, diseconomies
will set-in. The point where the average cost of the firm is lowest is considered as the optimum level of
output for the firm concerned. This is the optimum size of the firm with minimum average cost.

We can explain this with the help of Figure 13.4 We measure units of output on the OX-axis and cost of
production on the OY-axis. LAC is the long-run average cost curve. It indicates average cost of
production at different levels of production in the long-run. SAC 1 SAC2, etc are the short-run average
cost curves of different scales of firms. SAC 2 represents the short-run average cost curve, which produces
OM level of output with the minimum average cost at point T.

TM is the minimum average cost. At this level of output (OM), the cost per unit is the lowest with the
plant of SAC4 compared to that of the other plants. Suppose, the entrepreneur increases the size of the
plant beyond SAC4, various diseconomies of scale will result and the average cost of production will
increase.
140
 Similarly, as he decreases the size of the plant, which is smaller than SAC 4 the average cost of
production will also be high. This is because the scale of the plant is smaller and the producer will not be
able to avail all the economies of scale. Thus, SAC 4 is the position where the film will be functioning at
the optimum. ONI is the optimum level of output with the least-cost output of the firm. The firm which
produces the optimum level . of output with the optimum plant is known as an optimum firm.

13.9 SUMMARY

In this unit, we have discussed the characteristics of perfect competition. In the perfect competition, a
large number of producers and consumers deal with a homogeneous product where firms have the choice
of free entry and free exit. Equilibrium of a firm in perfect and imperfect competitions depends on two
conditions, namely MC = MR, and MC curve must cut MR curve from below. In perfect competition, the
firm will be in equilibrium when it gets abnormal profits or normal profits or even losses in the short run.
But, in the long-run, the firm will always get normal profits. The reason is that, when an industry gets
abnormal profits, other firms will enter this industry. In the same way if an industry gets losses a few
firms leave the industry in the long run. So in the long run firms will be in equilibrium when they get only
normal profits.
Here, one should not forget that industry is a group of firms producing an identical or similar commodity.
Optimum firm indicates optimum size of output where a firm incurs minimum average cost

13.10 ANSWERS TO CHECK YOUR PROGRESS EXERCISES

1. Perfect competition is the situation where large numbers of buyers and sellers have perfect knowledge
about the market for homogeneous products.
2. The following are the characteristics of perfect competition
i) Large number of buyers and sellers
ii) Homogeneous product
iii) Horizontal shape of demand curve
iv) Free entry and exit
v) Mobility of factors of production
vi) Absence of transport cost
vii) Perfect knowledge of market conditions

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13.11 MODEL EXAMINAMION QUESTION

1. Explain the conditions of equilibrium under perfect competition.

2. What is optimum firm?
3. Distinguish between pure and perfect competition.
4. List out the features of perfect competition.

13.12 REFERENCES

 Varian. R Hall (1999) Intennediate Microeconomics.

 Koutseyianniss A (1985) Modem Microeconomics.
 Gonld and Furguson (1985) Microeconomic Theory.
 Jhingan, M.L (1998) Microeconomic Theory.
 Barthwal, R.R (1992) Microeconomics Theory.

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UNIT 14: MONOPOLY AND IMPERFECT COMPETITION

Contents
14.0 Aims and Objectives
14.1 Introduction
14.2 Meaning of Monopoly
14.3 Kinds of Monopoly
14.4 Price Determination under Simple Monopoly
14.5 Perfect Competition and Monopoly
14.6 Monopoly Price Discrimination
14.7 Forms of Price Discrimination
14.8 Conditions for Price Discrimination
14.9 Distribution of Given Output under Discriminating Monopoly
14.10 Price and Output under Discriminating Monopoly
14.11 Monopolistic Competition
14.12 Oligopoly
14.13 Summary
14.14 Answers to Check Your Progress Exercises
14.15 Model Examination Questions
14.16 References

14.0 AIMS AND OBJECTIVES

This unit explains the three forms of imperfect competition: monopoly, monopolistic competition, and
oligopoly.
By the end of the unit, you will be able to:
 Define monopoly
 Determine the price under simple monopoly,and
 Differentiate monopoly from perfect competition.

14.1 INTRODUCTION

We have discussed how price and output are determined in perfect competition. In this unit, we shall see
how price and output are determined in imperfect competition. There are two limiting types of market
situations. One is pure competition which was already discussed in the previous unit. The other is pure

143
monopoly. In real life,we do not find either perfect competition or pure monopoly, but we find a region
of ‘imperfect’ competition lying between those limits.

14.2 MEANING OF MONOPOLY

In monopoly a product has only one producer. There are no close substitutes for the product. There are
low cross-elastics of demand with every other product. The price and output of the monopolized product
cannot perceptibility be affected by the other products. In other words, the monopolist cannot have
control over the price and output policies of other firms. The demand curve of a monopoly firm slopes
stably downward to the right. The producer is a price setter and the price set by him yields him maximum
profits. But this does not mean that he can decide both the price and the output. He can decide only one of
the two things. The producer either chooses for himself the level of output or he determines the price of
the product depending on the conditions of demand in the market. Once he fixes the price for his product,
he leaves the level of output to be "determined by the demand for the product at that price in the market.
In any event, the sole goal of the monopolist is to earn maximum profits.

The type of monopoly which was discussed above is called the simple or imperfect monopoly. We shall
briefly describe pure monopoly also, though our main concern is with simple monopoly and
discriminating monopoly.
In pure monopoly, there is only one producer. Competition even in this limited firm is absolutely absent.
This means that the producer has no rivals, no substitutes. Neither does the monopolist influence the
price-output policies of other firms nor are the price-output policies of his firm influenced by other firms.
In the words of Triff pure monopoly is that where cross-elasticity of demand of the monopolist's product
is zero". According to Stoner & Hague, "it (pure monopoly) would occur when the average revenue curve
of the firm was a rectangular hyperbola with an elasticity of demand equal to one, and when the
monopolist took the whole community's income all the time"
Pure monopoly never occurs in the real world. This limiting case is merely a theoretical one.

14.3 KINDS OF MONOPOLY

We shall now discuss the different kinds of monopoly

Natural Monopoly
There are certain commodities, which are available in a small or single place. Their supply is localized.
Such localization of any commodity in a single place is called natural monopoly. Diamonds are extracted

144
in South Africa. The extraction of diamonds is controlled by South Africa. India possesses manganese
mines. They are examples of natural monopolies.

Legal Monopoly
Any legal right which is sanctioned to a firm to produce a unique commodity is known as legal
monopoly. For example, if the right of manufacturing a medicine with the brand name has been given by
law to a company, no other company can produce the medicine using the same brand name. This type of
monopoly is what we find in the case of products produced by multi-nationals like petroleum companies,
pharmaceuticals, etc.

Public Monopoly
There are some utility services, which are meant for the welfare of the public. Such services are only
controlled and provided by public agencies and are called public utilities. Municipalities providing the
water supply, electricity, telephones, etc., are public monopolies.

Artificial Monopoly
Individual producers and firms create artificial monopolies for the purpose of maximizing profits. The
individual producers of the same product come together and form into a single organization so as to
liquidate competition among themselves and to maximize profits. Such types of amalgamation of
individual firms into single organization is known as artificial monopoly or private monopoly.

Exercise-1
1. What is monopoly?
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2. What is pure monopoly?
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3. What is natural monopoly?
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14.4 PRICE DETERMINATION UNDER SIMPLE MONOPOLY

Assumptions
We study here the determination of price, output, and profit under monopoly. The determination of price
is based on the following assumptions:
1. Simple monopoly
2. Very low cross-elasticity of demand with other goods
3. Rational monopoly
4. Aim of maximum profits
5. Full completion in terms
6. No price discrimination
7. Uncontrolled power of monopolist

Price and Output under Monopoly

Given these assumptions, the forces of demand and supply determine the price, output and profit under
monopoly. The supply of the product is completely governed by the monopolist. The price is fixed by the
monopolist to yield him the maximum profit .But both the price and the level of output cannot
simultaneously be controlled by him. He can either decide the level of output, or leave the price of the
output to be determined by consumer demand, or he can fix the price and leave the level of output to be
decided by the demand for the product at that price. Thus, the conditions of demand decide the price
fixation and the level of output to be produced by the monopolist

Under monopoly conditions, the demand curve or average revenue curve or sales curve slopes downward
to the right The average revenue curve will indicate that the monopolist can sell more only by reducing its
price. The AR curve has its corresponding MR curve, which lies below it If the AR curve is a negatively
sloping straight line, the MR curve will also be a straight line sloping negatively. The monopolist
influences price or output depending on the elasticity of demand for his product. If the elasticity of
demand is high for his product, he reduces the price and sells a greater quantity earning maximum profits.
If the elasticity of demand for his product is inelastic he raises the price, and by selling less he still gains
the maximum profits.
The monopolist can produce the most profitable output against the demand for his product. This will
depend on the conditions of supply. The cost of production may rise, fall, or remain constant.

If the cost of production rises, every increase in output will lead to an increase in cost per unit, and the
monopolist can produce less and fix a higher price. If the cost of production decreases, every increase in
output will lead to a decrease in cost per unit, and he will be able to fix a lower price. If the cost of
146
production remains constant, there will be no change in cost per unit with every increase in output, but the
price will be fixed according to the demand for the product. Whatever the cost of production may be, the
monopolist continues to produce the commodities as long as total revenue is greater than the total costs.
In other words, he continues to produce so long as additional units add more to revenue than to cost. That
is likely to happen irrespective of wherever the marginal cost (MC) curve cuts the MR curve while it is
falling, raising or perpendicular to the MR curve under monopoly conditions. In perfect competition
however, the firm will be in equilibrium when the MC curve cuts the MR curve from below. We shall
discuss the price-output equilibrium of the monopolist.

Price and Output Equilibrium under Monopoly

We have already said that the sole aim of the monopolist is to maximize profits. He goes on producing
goods until MR equals MC, where the firm will be in equilibrium. At this level of price-output, the profits
are maximum. The following figure reveals the price-output equilibrium of the monopolist.
AR is the average revenue curve; MR is the marginal revenue curve, AC is the average cost curve; and
MC the marginal cost curve. The monopolist continues his production up to OM level where MR equals
MC at point E. Thus, the firm is in equilibrium at E. As the production is increased beyond the OM level
when profits are maximized, the marginal revenue is less than the marginal cost. The firm will not be in
equilibrium, as it will earn less than maximum profits.

If we look at the average revenue curve or demand curve AR, we find that the OM output is sold in the
market at price OF. In Figure 14,1, the price or demand or average revenue is MF (=OP) corresponding to
the equilibrium output. Under the cost-revenue situation, where MC=MR at point E the firm will be in
equilibrium at output OM. The monopolist fixes a price equal to MF (=OP). MF or OP is the average
revenue and MG or OS is the average cost at the equilibrium output OM. PS or FG is the profit per unit

147
Now Total Revenue = AR x Output sold

=Op x OM= OPFM

Total Cost = AC x Output produced

=OS x OM= OSGM

Therefore, profits = TR -TC

= OPFM - OSGM

= SPFG (the shaded area )

or
Monopolist's Profits = Profits per unit x Total Output sold

= PS x OM
=PS x SG= OSPFG

The monopolist earns total profits equal to the shaded area rectangle SPFG, when the firm is in
equilibrium at E in Figure-14.1. Thus, the equilibrium price-output and profits are determined under
monopoly. Under monopoly conditions, when there is no competition, the total revenue earned by the
monopolist is greater than the total costs. Normal profits for the services of entrepreneurial capacities are
included in the total costs. When TR exceeds TC, the monopolist earns more than

normal profits and the extent of the excess profits earned by the monopolist may be called the degree of
exploitation. We need to study the causes for this exploit and consider who (among the four factors of
production employed in the process of production) gets exploited in this situation.
The exploitation may arise from the price, which is fixed at' a higher level than the cost incurred per unit
of AC in which normal profits are included. It may be difficult to say exactly who is exploited unless the
services rendered by different factors of production are calculated at the prevailing prices for them. Or the
monopolist may have exploited the customers by extracting more money from the pockets than he should
have. In imperfect competition, the exploitation is bound to occur in some form or the other. Exploitation
is inherent in imperfect competition. It is also inherent in perfect competition as it was pointed out by
Marx, but normal profits are treated in economic literature as just profits, which, under monopoly or
imperfect competition, are treated as the firm's abnormal profits.

148
l4.5 PERFECT COMPETITION AND MONOPOLY

When perfect competition is compared with monopoly, it may be considered superior to the latter because
of some merits that it has. Perfect competition and monopoly have some obvious similarities. The aim of
both the markets is to maximize profit. Firms in both the markets reach equilibrium situation when MR =
MC. But there are also fundamental differences between the two.
a) In perfect competition. There are a number of buyers and sellers. There is a distinction between a firm
and an industry. There is free competition among the producers. The forces of demand and supply
determine the price for the entire industry. All firms sell their product at the ruling price. No firm can
change the price by individual actions. Every firm adjusts its output to that price. There is only one price
for the same product throughout the market. On the other hand, the firm and industry are one and the
same under monopoly. The producer is a price-setter. There is only a single firm and there is no
competition.
b) In perfect competition, the AR curve or demand curve of a firm is a horizontal straight line parallel to
the OX-axis. It is perfectly elastic. The marginal revenue
Curve coincides with it. Under monopoly, the AR curve of a firm slopes downward to the right and the
MR curve lies below it.
c) Under perfect competition and monopoly, the firms reach the equilibrium stage under the same
conditions, i.e. MC=MR. But there is a difference between price and marginal cost relationship. Under
perfect competition when a firm is in equilibrium, MC=MR and MR=AR ,because MR coincides with
AR. Then, the marginal cost is equal to MR and AR as they are horizontal straight lines parallel to the
OX-axis. Under monopoly, AR slopes downward to the right and MR also slopes down and lies below it.
That is why the MR does not coincide with AR. When a firm is in equilibrium MC=MR, but MC is not
equal to price, AR, but MC=MR<Price= (AR).
d) Under perfect competition, the firm is in the equilibrium position when the marginal cost curve cuts the
MR curve, the horizontal straight line. is that parallel to the OX- axis, from below, and the MC curve rises
upwards from left to right on the other hand, under monopoly, the firm is in equilibrium, when the MC
curve cuts the MR curve from below not only when the MC curve rises, or falls but when it is constant
because of MR sloping downward to the right.
e) In perfect competition, the firm in the long-run will earn only normal profits, but in the short-run it can
earn more than normal profits or losses. On the contrary, under monopoly, as there is only one firm in the
industry even if the firm incurs losses in the short-run, there is no chance for new firms to enter the
industry.
f) Some other important differences between perfect competition and monopoly are explained with the
help of the figure given below:

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Em = Monopoly Equilibrium (MR=MC)
Ec = Equilibrium in Perfect Competition (MR=AR=MC)
If we look at Figure 14.2, we notice that, under perfect competition, the firm reaches equilibrium at point
Ec when MR coincides with AR at the point where MC = MR = AR. The quantity produced is OQC and
the price is OPC. Under monopoly, the firm reaches equilibrium at Em where MC = MR < AR. The
quantity produced is OQM and the price is OPM. Let us compare output and price under both markets.
Take monopoly output. It is OQM which is less than the output produced under perfect competition OQC
and the price charged under monopoly is OPM, which is more than the price charged under perfect
competition OPC. This shows that under perfect competition, more goods are available at a lower price,
whereas under monopoly fewer goods are available at a higher price. Consumers thus forego surplus
under monopoly. That is why in recent times, there has been a growing demand that public utilities
which are under the control of public authorities like Provincial Governments should adopt marginal cost
pricing which will be beneficial to the consumer.

14.6 MONOPOLY PRICE DISCRIMINATION

Price discrimination means changing different prices from different consumers for different units of the
same product or service. According to Joan Robinson, “The act of selling one article, produced under
single control at different prices to different buyers is known as price discrimination. Price discrimination
will not occur under perfect competition. It only occurs in monopoly or in imperfect competition. The

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monopolist governs the supply of the product. That is why he charges different prices from different
buyers or in the different markets. The theory is an extension of monopoly pricing.

14.7. FORMS OF PRICE DISCRIMINATION

i) Personal Discrimination: This is based on the incomes of the consumers. Doctors and lawyers charge
higher fees to rich persons and lower fees to poor people for the same service.
ii) Nature of Product: Price discrimination depends on the nature of the production. Suppose there are two
types of editions of the same book, one is a paperback edition and the other is a deluxe edition. The
former is cheaper than the latter.
ii) Local Discrimination: This is based on the locality in which the product is sold. The monopolist
charges a high price in the domestic market for the product, whereas he charges a lower price in the
international market for the same product.
iv) Trade Distribution: This may also be called use discrimination. For example, the State Electricity
Board charges low rates for agricultural purposes, but it charges high rates for industrial use.

14.8. CONDITIONS FOR PRICE DISCRIMINATION

Here, we would look at important conditions for price discrimination. Price discrimination is possible
under imperfect competition or monopoly. If a monopolist is in a position to get profit by charging
different prices for different units of the same product, he will formulate a policy of price discrimination.
Price discrimination is practicable under the following conditions:

Separate Markets
There must be two separate markets. The buyer of one market should not move to the other market. The
monopolist will then be able to charge a high price for a product in one market and low price in other
market for the same product.

Different Elasticity’s of Demand

There must be different elasticity’s of demand for the same product. If the product possesses less
elasticity of demand in one market, then it should have more elasticity of demand in the other market. The
monopolist sets the profit by selling his products at different prices in different markets, which have
different elasticity of demand for the same product.
Here, we shall discuss the most common type of price discrimination. The monopolist classifies the
buyers into two categories. He charges different prices from different markets. The monopolist produces
certain amounts of commodities, which are sold in two separate markets. The cost of production is
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ignored here. This output is adjusted in each market such that the marginal revenue derived from the first
market equals the marginal revenue derived from the second market. Prices are different due to
differences in elasticity of demand in the two markets, but marginal services are not different.

14.9 DISTRIBUTION OF GIVEN OUTPUT UNDER DISCRIMINATING

MONOPOLY

We suppose that there are two distinct markets. We assume that the monopolist produces some amount of
output and wants to distribute the given output in the most profitable way between the two markets. Here,
the monopolist has discriminated the price for the product in the two different markets. Under the
seconditions, it is necessary that the elasticity of demand must be different in the two different markets.
We assume that market is less elastic and market-II is more elastic. The marginal revenues in the two
markets will also be different. Here, we ignore costs of production. The monopolist should distribute his
given output among the two markets. This distribution should be made in such a way that the marginal
revenue in one market is equal to the marginal revenue in the other. Then, only he can maximize his
profit. If the marginal revenue of market-I is greater than the marginal revenue of market-II, the
monopolist sells the additional units in market-I. He will continue this until the marginal revenues in each
market are made equal. If he continues the switching process still further, he losses because the marginal
revenue in market-I will eventually become less than the marginal revenue in the market II. Since the
elasticities of demand are different in the two markets, the monopolist will gain maximum profits from
the given output when the marginal revenues are equal in both the markets. This can be explained with
the help of figure 14.3.

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ARI and AR2 are the average revenue or demand curves of the two markets II and I respectively. MR 2 are
corresponding marginal revenue curves. Now, if the given output is below OQ l, the monopolist should sell
the entire quantity in market I because up to this level of output the marginal revenue of market I is
greater than the marginal revenue of market II. If his total output is equal to Q 1Q2 (OQl+OQ2), he should
sell OQl output in market I and OQ 2 in market II, so that marginal revenue in market I equals marginal
revenue in market II. The level of marginal revenue in both the markets will be equal to OM=Q 1M1=
Q2M2= MRl = MR2.
MRI== Marginal Revenue of Market I.
MR2= Marginal Revenue of Market ll.

This is the situation in which the monopolist is in equilibrium and at this point he maximizes total profits
from the given output. This distribution of output reveals that the price in market I will be OPI, and the
price in market II will be OP2. It is evident that the price in market I is higher than the price in market II.
But the output in market II is more than the output in market I. In other words, it is obvious that marginal
revenue in both the markets is same, but the prices are different In market I, the elasticity of demand is
less. As a result the price will be higher. In market II, the elasticity of demand curve is more, and the price
will be lower. We can prove this by the following mathematical formula.
MR=P (1/n)
Where MR = Marginal Revenue,
P = Price, and
n = Elasticity of demand.
Since in equilibrium
MR1 = MR2
Where Mr = P1(1 1/n2)
MR2=P2 (1 1/n2)
nl= elasticity of demand in market I
n2 = elasticity of demand in market II
Therefore, when elasticity in the two markets is not same, the prices in the markets will differ. Then there
is price discrimination. The price in market I is P 1 which differs from the price P2 in market II. Here, we
find that the price in market I is greater than the price in market II. The monopolist practices price
discrimination in different markets. If elasticities of demand are equal in both the markets, price will also
be the same in the two markets. In such a situation, we would not find price discrimination..
Let us assume n1 =3 and n2 =6. Applying these values in the above equations, we get
p1(1-1/3) = p2(1-1/6)
or 2/2p1=5/6p2
or p1=5/6x3/2p2=5/4p2

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Thus, PI >P2 if n1<n2 similarly if n1 =n2 then P1 = P2. Therefore, price discrimination is present only when
elasticities of demand in the two markets are different.

14.10. PRICE AND OUTPUT UNDER DISCRIMINATING MONOPOLY

We have dealt with the distribution of output in two different markets. To maximize profit, the
monopolist charges different prices in different markets. Price discrimination, the monopolist's method of
maximization of profits, is explained above ignoring the costs of production. Here, we shall explain price
discrimination and profit maximizations taking into account the costs of production. The aim of a
monopolist is to maximize his total profit. For this, he has to consider costs of production and revenues.
We assume, as we have done earlier, that there are two markets. The monopolist earns maximum profits
when marginal revenues in the two markets are equal. And at the same time, the marginal revenues are
also equal to the marginal costs of the monopolist's total production.

This can be explained with the help of figure 14.4(a,b,c).

Suppose, in figure -14.4, there are two markets, I & II, and ARI and AR 2 respectively are the average
revenue curves for them. MRI and MR2 are the corresponding marginal revenue curves respectively.
These two markets have different elasticities of demand at each price. Now, the monopolist must
determine his total output regardless of how it is distributed. For this, the monopolist follows the profit
maximization rule where MC =MR. We have shown in figure -14.4 (c) that total (combined) marginal
revenue (E MR) and the marginal cost curve (MC) for the total output. The total marginal revenue for the

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total output is the horizontal addition of the two separate marginal revenues MR 1 and MR2 of the
individual markets. Now the monopolist will be in equilibrium at point E where MC= E MR. OQ is the
equilibrium level of output. The monopolist faces the problem of distributing the OQ output between the
two markets, II and I. For this, he has to follow the rule MR 1= MR2 =MC =E MR. Following this rule,
OQ output should be sold in market " f I and OQ2 output in market II. As the monopolist distributes his
total output between the I. two markets, the marginal revenue OM 1 in market I is equal to the marginal
revenue OM2 in market II. EI and E2 are equilibrium points of market II and I respectively. The price in
market I is OPI and the price in market II is OP2. The monopolist earns total maximum profits, which are
equal to the shaded area DREM shown in figure1.4.4(c)

14.11 MONOPOLISTIC COMPETITION

Meaning
Monopolistic competition is that where there is large number of producers of a differentiated product in
the market. According to A.W. Stonier and D.C Hague, "There is competition which is keen though not
perfect between many firms making very similar products". In monopolistic competition, the price-output
policies will not be influenced by others. There is competition among large number of producers who
produce close but not perfect substitute goods. Monopolistic competition is sometimes known as group
equilibrium.

Characteristics of Monopolistic Competition

The main characteristics of monopolistic competition are.

i. Relatively small number of firms: In monopolistic competition sellers are less than that under perfect
competition. For this reason, the producers enjoy some monopoly power. Price-output decisions of
individual sellers will not influence other actions. There is an independent course of action. The producers
produce differentiated products and charge different prices for their products.

ii. Product differentiation: In monopolistic competition, product differentiation is an important feature.

According to prof. Chamberlains, there are many firms which produce a particular product, but the
product of each firm is in some way different from that of the other firm. Product differentiation may be
in the form of trademarks, patent rights, brand names, etc. Product differentiation means that the products
are different in some way from each other. They are heterogeneous. There is a slight difference between
one product and the other in the same category. Products are close substitutes with high cross elasticity
but not perfect substitutes. For example, toothpastes are produced by different companies under different
brand names like Colgate, close-up Cibaca, Forhans, etc.
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iii. Freedom of entry of new firm: Under Monopolistic competition, there is monopoly power to
individual firms for its product. The individual firm faces keen competition from other firms, which are
producing similar products. So the individual firm cannot restrict the entry of new firms. Each firm in a
way behaves like a monopolist, but it faces competition from others as it also sells almost a similar
product. That is why, it has been blend of monopoly and competition and named as monopolistic
competition.

iv. Competitive advertisement: The practice of competitive advertising is the important characteristic of
monopolistic competition. Advertisement creates some difference between two brands say X and Y in the
minds of the consumer though they may be almost identical in their technical or chemical composition.
Effective and efficient advertisement creates difference of images of the same product in the minds of
consumers due to which the products look different from the point of view of consumers. Thus,
advertisement technique is very important t feature of monopolistic competition. For example, every soap
producer advertises in all types of media like newspapers, radio, and television.

v. Downward sloping demand curve: The shape of demand curve is based on the product differentiation
under monopolistic competition. There is some monopoly power for the firm as there is product
differentiation. Due to the product differentiation, close substitutes are available.
Thus, the firm will have more elastic demand curve for its product. The demand curve under monopolistic
competition will be less steep as compared to that of monopoly firm. This means a slight fall in price will
lead to a large increase ill the demand for its product if the prices of other firms remain the same. The
demand curve slopes downward to the right.

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14.12 OLIGOPOLY

Meaning and Definition of Oligopoly

The term "Oligopoly" is derived from two Greek words. "Oligoi" means a few and "Pollein" means to
sell. Oligopoly represents the market situation where there are a few sellers of a particular commodity.
The commodity is a differentiated one. In oligopoly, there are a few sellers, whereas in
monopoly there is only one firm in the market. It also differs from perfect competition and monopolistic
competition where there are many sellers in the market. The actions of a seller, in oligopoly will be
reacted and taken into consideration by others in the market. He also reacts to the actions of others. In
oligopoly, a single seller has got sufficient important position in the market. He will take the changes of
other firms into consideration and determine price, output and sales activity of his product. The changes
in the output and price of one firm will affect the amount of output and price of other firms. Oligopoly
firms are interdependent, whereas perfect competition firms are independent. Duopoly is the simplest case
of oligopoly, where there are only two sellers.
Prof. Stigler defines oligopoly as the "situation in which a firm bases its market policy in part on the
expected behavior of a few close rivals". According to Prof. Left which", an oligopolistic industry is one
in which the number of sellers is small enough for the activities of a single seller to affect other firms and
for the activates of other firms to affect him, to.

Characteristics of Oligopoly
i) Very few sellers of the product: There are very few sellers in the market producing either homogeneous
or differentiated products. Pricing and output of a single firm will influence the price and output of the
industry. Each firm has a large share of the market, and it can affect the market activities by altering its
output.
ii) Interdependence: Under oligopoly, actions of one firm will be reacted by other firms. A single firm
will also take into account the actions of other firms. As there are close substitutes for the product, there
is high cross elasticity of demand for the products.
iii) Presence of monopoly power: There are a few sellers in oligopoly; that is why, collusion of firms is
possible. When they come to agreement, they will act as monopoly so that high price is charged for the
product. They will enjoy more than normal profits by raising the price. In this manner, firms will enjoy
monopoly power to some extent.
iv) Existence of price rigidity: In oligopoly, if any firm decreases its price,. The other firms would reduce
their prices to greater extent. With this type of price war, no one will benefit. Suppose, on the other
hand, a firm increases its price, others will not follow the rise in price. Therefore, no one would like to
decrease or increase the price. Thus, firms will stick to the price, which is called price rigidity.

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v) Differentiated product: In oligopoly, firms produce differentiated products, which are close
substitutes. When each has to stick to the prevailing price, it has to increase it sales by improving quality
and design and by spending more on advertising so as to meet consumers’ preferences.

14.13 SUMMARY

So far, we have discussed how price and output are determined in monopoly and discriminating
monopoly. We have tried to analyze the concepts of monopolistic competition and oligopoly. Monopoly
indicates the existence of one producer, no substitute commodities and no competition. A monopolist can
decide either the price or output of the commodity, but not both. In the monopoly, the firm gets abnormal
profits when price and output are in equilibrium. By understanding perfect competition and monopoly,
you can differentiate them on many grounds.
A monopolist can charge different prices from different consumers for the same product .Under
monopoly price discrimination, the monopolist He bifurcates (divides) the market on the basis of
elasticity of demand and sells the commodity at different prices. This enables him to earn more profits.

14.14 ANSWERS TO CHECK YOUR PROGRESS EXERCISES

1. In monopoly there will be only one producer, for a product. There are no substitutes for the product.
The price and output can not be affected by other products.
2. Pure monopoly means existence of a single producer and competition is absolutely absent. The
producer will not have rivals, no substitutes.
3. This arises due to the localization of any commodity in a single place.
Ex. The diamonds are extracted in South Africa.
The extraction of diamonds is controlled by South Africa.

14.15 MODEL EXAMINATION QUESTIONS

1. List the kinds of monopoly

2. What is monopoly?
3. What is monopolistic competition?
4. Define oligopoly.
5. Explain the characteristics of monopoly.

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14.16 REFERENCES

 Varian. R Hall (1999) Intermediate microeconomics.

 Koutseyianniss A (1985) Modem microeconomics.
 W Gonld and Furguson (1985) microeconomic theory.
 Jhingan, M;L (1998) microeconornic theory.
 Barthwal, R.R (1992) microeconomic theory.

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Assignment

1. Distinguish between inductive and deductive methods

2. Explain the relationship between micro economics and macroeconomics.
1. What is meant by normative and positive economics?
2. Explain two approaches in inductive method.
3. Explain the equilibrium price.
3. What is a market period?
4. Explain the price determination in the market period.
5. What is monopoly?
6. What is pure monopoly?
1. . What is monopolistic competition?
2. Define oligopoly

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