BUSINESS ECONOMICS AN INTRODUCTION

Economics
Economics as a branch of knowledge is concerned with the study of the allocation of scare resources
among competing ends (wants).
According to robbins, economics is the science which studies human behavior as a relationship
between ends and scares which have alternative uses.
Managerial Economics
anagerial economics (sometimes referred to as business economics), is a branch of economics that
applies microeconomic analysis to decision methods of businesses or other management units.
anagerial economic refers to the application of economic theory and the tools of analysis of
decision science to e!amine how an organi"ation achieve its aims or ob#ectives most efficiently.
According to $rof. %auge, anagerial Economics is concerned with using logic of economics,
mathematics & statistics to provide effective ways of thinking about business decision problems.
Nature of Managerial Economics
anagerial economics incorporates elements of both micro and macroeconomics dealing
with managerial problems in arriving at optimal decisions.
't aims in providing help in making decisions.
't helps the firm in forecasting the level of demand at some future point.
(oth science and arts) *he term science has been defined as the systemati"ed body of
knowledge, which traces the relationship between cause & effect. An arts is a system of
rules for the attainment of a given end. An art is application of knowledge and practical
application. Economic has all these feature of being an art.
Scope of Managerial Economics
+emand analysis and forecasting ) +emand forecasting is the process of finding the values
for demand in future time period. ,orrect estimates of demand is essential for decision
making, strengthening market position and enlarging profits.
,ost and $roduction Analysis) $roduction deals with the physical aspects of the business
investment. 't is the process whereby inputs are transformed into outputs. A production
function is the relation which gives us the technically efficient way of producing the output
given the inputs. Actually cost is the monetary side of production. -iven the production
function, one can go for cost estimation and forecasting.
'nventory anagement) 't refers to stock of raw materials which a firm keeps. anagerial
economics with methods such as A(, analysis a simple simulation e!ercise and some
mathematical models with a view to minimi"e inventory cost. 't also helps in aspects of
inventory control and cost of carrying them.
Advertising) anagerial economics helps in determining the total advertising cost and
budget, the measuring form an integral part of decision making and forward planning.
arket .tructure and $ricing $olicies) anagerial economics helps to clear surplus and
e!cess demand to bring market e/uilibrium as there is continuous change in market.
.uccess of business firm depends on correctness of price decisions. $rice theory works
according to the nature of the market depending on the number of sellers, demand conditions
etc.
0esource Allocation) anagerial economics with the help of advanced tools such as linear
programming are used to arrive at the best course of action for the ma!imum use of the
available resources and its substitutes.
,apital (udgeting) anagerial economics helps in decision making and forward planning
on allocation of capital to various factors of productions, marketing and management.
'nvestment Analysis) 't involves planning and control capital e!penditure. anagerial
economics help in analysis and decision making on the investment of funds.
0isk and 1ncertainty Analysis) As business firm have to operate under conditions of risk
and uncertainty both decision making and forward planning becomes difficult. %ence
managerial economics helps the business firm in decision making and formulating plans on
the basis of past data, current information and future prediction.
Business Economics Vs. Economics
S. No. Basis Business Economics Economics
2. 3ature 't deals with application Economics deals with
of economics principles the body of the
to the problems of business principles itself.
firms.
4. .cope of study 't deals with the problems 't deals with the
of the business firms. economic problems of
the firms and individual.
5. 6ocus of .tudy *he main focus of study 6ocuses on theories like
of business economics is rent, wage and interest
profit theory. along with profit theory.
7. Approach of .tudy odifies e!isting economic -enerates new
models. economic models.
Application of managerial economics
*ypical managerial decision making may involve one of the following issues)
+eciding the price of a product and the /uantity of the commodity to be produced.
+eciding whether to manufacture a product or to buy from another manufacturer.
,hoosing the production techni/ue to be employed in the production of a given product.
+eciding on the level of inventory a firm will maintain of a product or raw material.
+eciding on the advertising media and the intensity of the advertising campaign.
aking employment and training decisions.
aking decisions regarding further business investment and the mode of financing the
investment.
't should be noted that the application of managerial economics is not limited to profit8seeking
business organi"ations. *ools of managerial economics can be applied e/ually well to decision
problems of nonprofit organi"ations.
Micro Vs. Macro
S. No. Basis Micro Macro
2. .tudy 'ndividual Economy as a whole
4. +eal 9ith 'ndividual 1nits Aggregate 1nits
5. *ools +emand & .upply of a Aggregate +emand
$articular commodities and Aggregate .upply
of Economy as a whole.
7. ,entral $roblem $rice +etermination of +etermine :evel of
,ommodities or factors 'nco8me &
;f production Employment
<. $rices 0elative $rices +ecide Absolute $rice +ecide
=. *ype of Analysis $article E/ui Analysis -eneral E/ui Analysis
>. .cope 3arrow 9ider
?. 1nderstanding Easier ,omple!

MANAERIA! ECONOMICS AND OT"ER SCIENCES
MANAERIA! ECONOMICS AND STATISTICS
.tatistics provides several tools to anagerial Economics@ .tatistical techni/ues are used in
collecting, marshalling and analysing business data that makes possible an empirical testing of the
economic generalisations before they are applied for decision making. Economic generalisations
cannot be fully accepted until they are verified and found Aalid against the real data. *he theory of
probability and forecasting techni/ues help the manager indecision8making process. 9hen the
manager is to meet with the reality of uncertainty in decision making the theory of probability
provides the logic for dealing with such uncertainty.
MANAERIA! ECONOMICS AND MAT"EMATICS
athematics is especially of to the manager when several economic relationships are to logic in the
analysis of economic events provides clarity of the concepts and also helps to establish a /uantitative
relationship. anagers deal primarily with concepts that are /uantitative in nature eg., demand,
price, cost, capital, wages, inventories etc. athematics is the managerBs most useful logical tool.
MANAERIA! ECONOMICS AND O#ERATIONS RESEARC"
;peration research and managerial economics are related to a certain e!tent. ;peration research is
the application of mathematical and statistical techni/ues in solving business problems. 't deals with
construction of mathematical models that helps the decision making process. ;peration research is
helpful in business firms in studying the inter8relationship and relative efficiencies of various
business aspects like sales, production etc. :inear programming, techni/ues of inventory control,
game theory etc. are used in managerial economics. *hese are used to find out the optimum
combination of various factors to achieve the ob#ects of ma!imisation of profit, minimi"ations of
cost and time etc.
MANAERIA! ECONOMICS AND ACCOUNTIN
Accounting is closely related with managerial economics. Accounting is the main source of data
regarding the operation and functioning of the firm. Accounting data and statements represent the
language of the business. A business manager needs market information, production information and
accounting information for decision8making. *he profit and loss statement reflects the operational
efficiency of the firm. *he balance sheet tells the financial position of the firm. *he accounting
information provides a basis for the manager in decision making and forward planning. 'n short,
accounting provides right information to take right decisions.

DEMAND ANA!$SIS
Deman%
+emand for a particular good by a consumer means the /uantities of the goods that he is willing to
buy at different prices within a given period of time.
*here are three important things about the demand)
't is the /uantity desired at a given price.
't is the demand at a price during a given time.
't is the /uantity demanded per unit of time.
Determinants of Deman%
*here are many important determinants of the demand for a commodity)
$rice of the goods) *he first and foremost determinant of the demand for good is price.
1sually, higher the price of goods, lesser will be the /uantity demanded of them.
'ncome of the buyer) *he si"e of income of the buyers also influences the demand for a
commodity. ostly it is true that Clarger the income, more will be the /uantity demandedC.
$rices of 0elated -oods) 0elated goods are kept in two categories)
a. Substitute goods (Direct relationship)) .ubstitute goods are those which can be used in
place of each other. +emand for a given commodity is affected if price of its substitute
falls or rises, e.g., $epsi and ,oca8,ola, *ea and ,offee, etc.
b. Complementary goods (Inverse relationship)) ,omplementary goods are those which are
used together to satisfy a given want. A fall in price of one commodity leads to rise in
the demand of other commodity also, e.g., car and petrol, etc.
*astes of the buyer) *his is a sub#ective factor. A commodity may not be purchased by the
consumer even though it is very cheap and useful, if the commodity is not up to his taste or
liking. ,ontrarily, a good may be purchased by the buyer, even though it is very costly, if it
is very much liked by him.
.easons prevailing at the time of purchase) 'n winter, the demand for woolen clothes will
rise@ in summer, the demand for cold drinks rises substantially@ in the rainy season, the
demand for umbrellas goes up.
6ashion) 9hen a new film becomes a success, the type of garments worn by the hero or the
heroine or both becomes an article of fashion and the demand goes up for such garments.
Advertisement and .ales promotion) Advertisement in newspapers and maga"ines, on
outdoor hoardings on buses and trains and in radio and television broadcasts, etc. have a
substantial effect on the demand for the good and thereby improves sales.
!a& of Deman%
:aw of demand states that the /uantity demanded of a commodity is inversely related to the price
of the commodity, other things remaining the same.
Deman% Sc'e%ule
't is a list of alternative hypothetical prices and the /uantities demanded of a good corresponding to
these prices. 't refers to the series of /uantities an individual is ready to buy at different prices. An
imaginary demand schedule of an individual for apples is given below)
+emand of a ,onsumer for apples
Price of apple Quantity demanded of apples
per unit (in rupees) (in dozens)
< 2
7 4
5 5
4 7
Assuming the individual to be rational in his purchasing behaviour, the above schedule illustrates the
law of demand. At 0s.<D8 per apple, the consumer demands 2 do"en of apples@ at 0s.7D8 per unit 4
do"ens, at 0s.5D8 per unit 5 do"ens and at 0s.4DE per unit 7 do"ens. *hus the inverse relationship
between price and demand is shown in the demand schedule.
Deman% Cur(e
9hen the data presented in the demand schedule can be plotted on a graph with /uantities demanded
on the hori"ontal or F8 a!is and hypothetical prices on the vertical or G8 a!is, and a smooth curve is
hypothetical prices on the vertical or G8 a!is, and a smooth curve is drawn Hoining all the points so
plotted, it gives a demand curve. *hus, the demand schedule is translated into a diagram known as
the demand curve.




Mo(ements in Deman% Cur(e )E*tension an% Contraction of Deman%+
*he change in demand due to change in price only (when other factors remain constant) is called
e!tension and contraction of demand. 'ncrease in demand due to fall in price is called e!tension of
demand. +ecrease in demand due to rise in price is called contraction of demand. E!tension and
,ontraction of demand results in movement on the same demand curve. 't is shown in the following
diagram)
G
+ contraction
$
2
$
$
4
e!tension


9hen price is ;$, the /uantity demanded is ;I. .uppose the price falls from ;$ to ;$4 demand
will be increased to ;I4. *his is a downward movement along the demand curve + from a to c.
*his indicates e!tension of demand. 9hen the price rises to ;$2, the demand will be decreased to
;I2, this is an upward movement along the demand curve from a to b. *his indicates contraction of
demand.
S'ift in Deman% Cur(e
9e have seen that the demand depends not only on price but also on other factors like income,
population, taste and preference of consumers etc. *he change in demand due to change in any of the
factors other than the price is called shift in demand. ,hange in any one of the factors shifts the
entire demand curve. A change in demand will shift the demand curve either upwards or downwards.
An upward shift in demand curve is called increase in demand. +ownward shift in demand curve is
called decrease in demand.
.hift in demand is shown in the following diagram)
decrease

$
increase

+ is the original demand curve. 9hen the demand increases, (e.g., due to increase in income) the
curve will shift upwards to +
2
without any increase in price. 't is constant at ;$. .imilarly when the
demand decreases, (e.g., due to decrease in income) the curve will shift downwards to +
4
. *he price
remains constant. *hus e!tension of demand is different from increase in demand. :ikewise,
contraction of demand doesnBt mean decrease in demand.
,'- t'e %eman% cur(e slopes %o&n&ar%s.
:aw of demand states the inverse relationship between price of a commodity and /uantity
demanded, other things remaining the same. *he demand of a commodity is more at a lower price
and less at a higher price. *hat is why the demand curve slopes downward. *he factors responsible
for the downward slope of demand curve are)
:aw of diminishing marginal utility) *he law of diminishing marginal utility states that as
the consumption of a commodity by a consumer increases the satisfaction obtained by the
consumer from each additional unit of the commodity goes on diminishing.
'ncome effect) A fall in the price of the commodity increase the purchasing power of the
consumer, in other words the consumer has to spend less to buy the same /uantity of the
commodity as before. *hus a fall in the price of this commodity increases its demand. *his
is called income effect.
.ubstitution effect) *his also increases demand as a result of a fall in the price of the
commodity and vice8versa. 9hen the price of a commodity falls it becomes relatively
cheaper than other commodity whose prices have not fallen. .o the consumer substitutes this
commodity for other commodities which are now relatively dearer. *his is known as
substitution or complementarily effect.
,hanges in the number of consumers) any people cannot afford to buy a commodity at a
high price. 9hen price of a commodity falls, the number of persons who could not afforded
at a higher price can purchase it at a reduced price. *his increases the consumer of the
commodity. *hus at a lower price the /uantity demand of the commodity increases because
of increase in the number of consumers of the commodity and vice versa.
+iverse 1ses of the commodity) any commodities can be put to several uses. *he
commodity having several uses is set to have composite demand.
E*ceptions to t'e !a& of Deman%
1nder certain circumstances the inverse relationship between price and demand does not hold good.
*hese are known as the e!ceptions to the law of demand.
.ome of the important e!ceptions are)
-iffen goods) *hese are special type of inferior goods. A rise in the price of giffen goods
leads to a rise in their demand and vice8versa.
,onspicuous necessities) Another e!ception occur in case of such commodities as though
their constant use is because of fashion or prestige value attached to them have become
necessity of life. Even though their price rises continuously their demand does show any
tendency to fall.
,onspicuous consumption) A few goods like diamond etc. purchased by rich persons of the
society because the prices of those goods are so high that they are beyond the reach of the
common man. ore of these commodities is demanded when their prices go up very high.
*he law of demand does not apply.
6uture changes in price) %ousehold also act as speculators when the price are rising, the
house hold tend to buy larger /uantity of the commodity out of apprehension that the prices
may go up further. :ikewise when prices are e!pected to fall further a reduced price may not
be sufficient incentive to induce the household to buy more. E.g. share market.
Emergencies) Emergencies like war, famine, flood etc. may negate the operations of lay of
demand. At such time the household may behave in a abnormal way. %ousehold accentuate
scarcity and induce further price rises by making increase purchases even at higher prices
during such period. +uring depression, on the other hand, no amount of falling price is
sufficient inducement for consumer to demand more.
,hange in fashion) A change fashion entails effect demand for a commodity.
'gnorance) ,onsumerJs ignorance is another factor that at times induces him to buy more of
commodity at a higher price. *his happens when the consumer thinks that a high price
commodity is better in /uality than low price commodity.
T-pes of Deman%
*here are three types of demands are)
$rice +emand) 't refers to the various /uantities of the good which consumers will purchase
at a given time and at certain hypothetical prices assuming that other conditions remain the
same. 9e are generally concerned with price demand only. 'n the e!planation of the law of
demand given above, we dealt in detail with price demand only.
'ncome demand) 'ncome demand refers to the various /uantities of a commodity that a
consumer would buy at a given time at various levels of income. -enerally, when the
income increases, demand increases and vice versa.
,ross +emand) 9hen the demand of one commodity is related with the price of other
commodity is called cross demand. *he commodity may be substitute or complementary.
.ubstitute goods are those goods which can be used in case of each other. 6or e!ample, tea
and coffee, ,oca8cola and $epsi. 'n such case demand and price are positively related. *his
means if the price of one increased then the demand for other also increases and vise8versa.
,omplementary goods are those goods which are #ointly used to satisfy a want. 'n other
words, complementary goods are those which are incomplete without each other. *hese are
things that go together, often used simultaneously. 6or e!ample, pen and ink.
*ennis rackets and tennis balls, cameras and film, etc. 'n such goods the price and demand are
negatively related. *his means when the price of one commodity increases the demand for the other
falls.
Ot'er T-pes of Deman%
Hoint demand) 9hen several commodities are demanded for a #oint purpose or to satisfy a
particular want. 't is a case of a #oint demand. ilk , sugar and tea dust are #ointly demanded
to make tea. .imilarly, we may demand paper, pen and ink for writing. +emand for such
commodities in bunch is known as #oint demand. +emand for land, labour, capital and
organisation for producing commodity is also a case of #oint demand.
,omposite demand) *he demand for a commodity which can be put to several uses is a
composite demand. 'n this case a single product is wanted for a number of uses. 6or
e!ample, electricity is used for lighting, heating, for running the engine, for the fans etc.
.imilarly coal is used in industries, for cooking etc.
+irect and +erived demand) *he demand for a commodity which is for direct consumption,
i.e., +emand for ultimate ob#ect, is called direct demand, e.g food, cloth, etc. +irect demand
is called autonomous demand. %ere the demand is not linked with the purchase of some
main products. 9hen the commodity is demanded as a result of the demand for another
commodity or service, it is known as the derived demand or induced demand. 6or e!ample,
demand for cement is derived from the demand for building construction@ demand for tires is
derived from the demand for cars or scooters, etc.
INDI//ERENCE CURVE ANA!$SIS
An indifference curve is a curve which represents all those combinations of goods which give same
satisfaction to the consumer. .ince all the combinations on an indifference curve give e/ual
satisfaction to the consumer, the consumer is indifferent among them. 'n other words, since all the
combinations provide same level of satisfaction the consumer prefers them e/ually and does not
mind which combination he gets.
*o understand indifference curves let us consider the e!ample of a consumer who has one unit of
food and 24 units of clothing. 3ow we ask the consumer how many units of clothing he is prepared
to give up to get an additional unit of food, so that his level of satisfaction does not change. .uppose
the consumer says that he is ready to give up = units of clothing to get an additional unit of food. 9e
will have then two combinations of food and clothing giving e/ual satisfaction to consumer)
,ombination A has 2 unit of food and 24 units of clothing, combination ( has 4 units of food and =
units of clothing. .imilarly, by asking the consumer further how much of clothing he will be
prepared to forgo for successive increments in his stock of food so that his level of satisfaction
remains unaltered, we get various combinations as given below)
'ndifference .chedule
Combination Food Clothing !S
A 2 24
( 4 = =
, 5 7 4
+ 7 5 2
3ow if we draw the above schedule we will get the following figure.
'n figure, an indifference curve ', is drawn by plotting the various combinations of the indifference
schedule. *he /uantity of food is measured on the F a!is and the /uantity of clothing on the G a!is.
As in indifference schedule, combinations lying on an indifference curve will give the consumer
same level of satisfaction.

In%ifference Map
A set of indifference curves is called indifference map. An indifference map depicts complete picture
of consumerBs tastes and preferences. 'n 6igure K, an indifference map of a consumer is shown which
consists of three indifference curves.
9e have taken good F on F8a!is and good G on G8a!is. 't should be noted that while the consumer
is indifferent among the combinations lying on the same indifference curve, he certainly prefers the
combinations on the higher indifference curve to the combinations lying on a lower indifference
curve because a higher indifference curve signifies a higher level of .satisfaction. *hus while all
combinations of ',, give same satisfaction, all combinations lying on ',
4
give greater satisfaction
than those lying on ',
2
.
Marginal Rate of Su0stitution
arginal 0ate of .ubstitution (0.) is the rate at which the consumer is prepared to e!change
goods F and G ,onsider *able84. 'n the beginning the consumer is consuming 2 unit of food and 24
units of clothing. .ubse/uently, he gives up = units of clothing to get an e!tra unit of food, his level
of satisfaction remaining the same. *he 0. here is =. :ike wise which he moves from ( to , and
from , to + in his indifference schedule, the 0. are 4 and 2 respectively. *hus, we can define
0. of F for G as the amount of G whose loss can #ust be compensated by a unit gain of F in such a
manner that the level of satisfaction remains the same. 9e notice that 0. is falling i.e., as the
consumer has more and more units of food, he is prepared to give up less and less units of cloths.
*here are two reasons for this.
2. *he want for a particular good is satiable so that when a consumer has its more /uantity, his
intensity of want for it decreases. *hus, when consumer has more units of food his intensity
of desire for additional units of food decreases.
4. ost of the goods are imperfect substitutes of one another. 'f, they could substitute one
another perfectly. 0. would remain constant.
#roperties of In%ifference Cur(es

*he following are the main characteristics or properties of indifference curves)
'ndifference curves slope downward to the right) *his property implies that when the
amount of one good in combination is increased, the amount of the other good is reduced.
*his is essential if the level of satisfaction is to remain the same on an indifference curve.
'ndifference curves are always conve! to the origin) 't has been observed that as more and
more of one commodity (F) is substituted for another (G), the consumer is willing to part
with less and less of the commodity being substituted (i.e. G). *his is called diminishing
marginal rate of substitution. *hus in our e!ample of food and clothing, as a consumer has
more and more units of food, he is prepared to forego less and less units of clothing. *his
happens mainly because want for a particular good is satiable and as a person has more and
more of a good, his intensity of want for that good goes on diminishing. *his diminishing
marginal rate of substitution gives conve! shape to the indifference curves. %owever, there
are two e!treme situations. 9hen two goods are perfect substitutes of each other, the
indifference curve is a straight line on which 0. is constant. And when two goods are
perfect complementary goods (e.g. gasoline and water in a car), the indifference curve will
consist of two straight line with a right angle bent which is conve! to the origin or in other
words, it will be : shaped.
'ndifference curves can never intersect each other) 3o two indifference curves will intersect
each other although it is not necessary that they are parallel to each other. 'n case of
intersection the relationship becomes logically absurd because it would show that higher and
lower levels are e/ual which is not possible.
A higher indifference curve represents a higher level of satisfaction than the lower
indifference curve) *his is because combinations lying on a higher indifference curve
contain mere of either one or both goods and more goods are preferred to less of them.
(udget line) A higher indifference curve shows a higher level of satisfaction than a lower
one. *herefore, a consumer in his attempt to ma!imise satisfaction will try to reach the
highest possible indifference curve. (ut in his pursuit of buying more and more goods and
thus obtaining more and more satisfaction he has to work under two constraints) firstly, he
has to pay the prices for the goods and, secondly, he has a limited money income with which
to purchase the goods.
*hese constraints are e!plained by budget line or price line. 'n simple words a budget line
shows all those combinations of two goods which the consumer can buy spending his given
money income on the two goods at their given prices. All those combinations which are
within the reach of the consumer (assuming that he spends all his money income) will lie on
the budget line.
't should be noted that any point outside the given price line, like %, will be beyond the reach of the
consumer and any combination lying within the line, like L, shows under spending by the consumer.
CONSUMER E1UI!IBRIUM
A consumer is in e/uilibrium when he is deriving ma!imum possible satisfaction from the goods and
is in no position to rearrange his purchases of goods. 9e assume that)
2. *he consumer has a given indifference map which shows his scale of preferences for various
combinations of two goods F and G.
4. *e has a fi!ed money income which he has to spend wholly on goods F and G.
5. $rices of goods F and G are given and are fi!ed for him.
7. *o show which combination of two goods F and G the consumer will buy to be in
e/uilibrium we bring his indifference map and budget line together.
9e know by now, that the indifference map depicts the consumerBs preference scale between various
combinations of two goods and the budget line shows various combinations which he can afford to
buy with his given money income and prices of the two goods. ,onsider 6igure 24, in which ',
2
,
',
4
, ',
5
, ',
7
and ',
<
are shown together with budget line $: for good F and good G. Every
combination on budget line $: costs the same. *hus combinations 0, ., I, * and % cost the same to
the consumer. *he consumerBs aim is to ma!imi"e his satisfaction and for this he will try to reach
highest indifference curve.
(ut since there is a budget constraint he will be forced to remain on the given budget line, that is he
will have to choose any combinations from among only those which lie on the given price line.
9hich combination will he chooseM .uppose he chooses 0, but we see that 0 lies on a lower
indifference curve ',
2
, when he can very well afford ., I or * lying on higher indifference curve.
.imilar is the case for other combinations on ',
2
, like %. Again, suppose he chooses combination .
(or *) lying on ',
4
. (ut here again we see that the consumer can still reach a higher level of
satisfaction remaining within his budget constraints i.e., he can afford to have combination I lying
on ',
5
because it lies on his budget line. 3ow what if he chooses combination IM 9e find that this is
the best choice because this combination lies not only on his budget line but also puts him on highest
possible indifference curve i.e., ',
5
. *he consumer can very well wish to reach ',
7
or ',
<
, but these
indifference curves are beyond his reach given his money income. *hus the consumer will be at
e/uilibrium at point I on ',
5
. 9hat do we notice at point IM 9e notice that at this point, his budget
line $: is tangent to the indifference curve ',
5
. 'n this e/uilibrium position (at I), the consumer will
buy ; of F and ;3 of G
At the tangency point I, the slopes of the price line $: and indifference curve ',
5
are e/ual. *he
slope of the indifference curve shows the marginal rate of substitution of F for G
0.
!y
N 1
!
1
y
while the slope of the price line indicates the ratio between the prices of two goods i.e., $
!
$
y
At e/uilibrium point I,
0.
!y
N 1
!
N $
!
1
y
$
y

*hus, we can say that the consumer is in e/uilibrium position when price line is tangent to the
indifference curve or when the marginal rate of substitution of goods F and G is e/ual to the ratio
between the prices of the two goods.

E!ASTICIT$ O/ DEMAND
*he concept of price8elasticity of demand was first of all introduced in economics by +r. arshall.
'n simple words, price elasticity of demand is the ratio of percentage change in /uantity demanded
to the percentage change in price. 'n other words, it means the rate or th degree of response in
demand to the change in price. *hus, the co8efficient of price8elasticity of demand can be e!pressed
as under)
E
d
N $roportionate change in Iuantity +emanded
$roportionate change in price
According to Alfre% Mars'all, CElasticity of demand may be defined as the percentage change in
/uantity demanded to the percentage change in price.C
According to 2.M. 3e-nes, C*he elasticity of demand is a measure of the relative change in /uantity
to a relative change in price.C
Degrees of #rice elasticit-

+ifferent commodities have different price elasticities. .ome commodities have more elastic demand
while others have relative elastic demand. (asically, the price elasticity of demand ranges from "ero
to infinity. 't can be e/ual to "ero, less than one, greater than one and e/ual to unity.
%owever, some particular values of elasticity of demand have been e!plained as under)
$erfectly Elastic +emand) $erfectly elastic demand is said to happen when a little change in
price leads to an infinite change in /uantity demanded. A small rise in price on the part of
the seller reduces the demand to "ero. 'n such a case the shape of the demand curve will be
hori"ontal straight line as shown in figure
*he figure shows that at the ruling price ;$, the demand is infinite. A slight rise in price will
contract the demand to "ero. A slight fall in price will attract more consumers but the elasticity of
demand will remain infinite. (ut in real world, the cases of perfectly elastic demand are e!ceedingly
rare and are not of any practical interest.
$erfectly inelastic +emand) $erfectly inelastic demand is opposite to perfectly elastic
demand. 1nder the perfectly inelastic demand, irrespective of any rise or fall in price of a
commodity, the Iuantity demanded remains the same. *he elasticity of demand in this case
will be e/ual to "ero. 'n diagram 27, ++ shows the perfectly inelastic demand. At price ;$,
the /uantity demanded is ;I. 3ow, the price falls to ;$
2
, from ;$, demand remains the
same. .imilarly, if the price rises to ;$
4
the demand still remains the same. (ut #ust as we
do not see the e!ample of perfectly elastic demand in the real world, in the same it is
difficult to come across the cases of perfectly inelastic demand because even demand for
bare essentials of life does show some degree of responsiveness to change in price.
1nitary Elastic +emand) *he demand is said to be unitary elastic when a given
proportionate change in the price level brings about an e/ual proportionate change in
/uantity demanded, *he numerical value of unitary elastic demand is e!actly one i.e., edN 2.
arshall calls it unit elastic.
'n figure, ++ demand curve represents unitary elastic demand. *his demand curve is called
rectangular hyperbola. 9hen price is ;$, the /uantity demanded is ;I. 3ow price falls to
;$
2
, the /uantity demanded increases to ;I2. *he shaded area in the fig. e/ual in terms of
price and /uantity demanded denotes that in all cases price elasticity of demand is e/ual to
one.
0elatively Elastic +emand) 0elatively elastic demand refers to a situation in which a small
change in price leads to a big change in /uantity demanded. 'n such a case elasticity of
demand is said to be more than one. *his has been shown in figure.
'n fig., ++ is the demand curve which indicates that when price is ;$ the /uantity
demanded is ;I , 3ow the price falls from ;$ to ;$
2
, the /uantity demanded increases
from ;I
2
to ;I
4
i.e. /uantity demanded changes more than the change in price.
0elatively 'nelastic +emand) 1nder the relatively inelastic demand a given percentage
change in price produces a relatively less percentage change in /uantity demanded. 'n such a
case elasticity of demand is said to be less than one as shown in figure 2>.
All the five degrees of elasticity of demand have been shown in figure 2?. ;n ;F a!is, /uantity
demanded and on ;G a!is price is given. 't shows)
2. A( 88 $erfectly 'nelastic +emand
4. ,+ 88 $erfectly Elastic +emand
5. EI 88 :ess *han 1nitary Elastic +emand
7. E6 88 -reater *han 1nitary Elastic +emand
<. 3 88 1nitary Elastic +emand.
/actors %etermining elasticit- of Deman%
*he factors that determine elasticity of demand are numberless. (ut the most important among them
are the nature, uses and prices of related goods and the level of income. *hey are stated below)
3ature of the commodity) -enerally, all commodities can be dividend into three categories
i.e.
a. 3ecessaries of :ife) 6or necessaries of life the demand is inelastic because people buy
the re/uired amount of goods whatever their price. 6or e!ample, necessaries such as
rice, salt, cloth are purchased whether they are dear or cheap.
b. ,onventional 3ecessaries) *he demand for conventional necessaries is less elastic or
inelastic. $eople are accustomed to the use of goods like into!icants which they
purchase at any price. 6or e!ample, drunkards consider opium and wine almost as a
necessity as food and water. *herefore, they buy the same amount even when their
prices are higher and highest.
c. :u!ury ,ommodities) *he demand for lu!ury is usually elastic as people buy more of
them at a lower price and less at a higher price. 6or e!ample, the demand of lu!uries
like silk, perfumes and ornaments increases at a lower price and diminishes at a higher
price. %ere, we must keep in mind that lu!ury is a relative term, which varies from
person to person, place to place and from time to time. 6or e!ample, what is a lu!ury to
a poor man is a necessity to the rich. *he lu!ury of the past may become a necessity of
today. .imilarly a commodity which is a necessity to one class may be a lu!ury to
another. %ence, the elasticity of demand in such cases should have to be carefully
e!pressed.
.ubstitutes) +emand is elastic for those goods which have substitutes and inelastic for those
goods which have no substitutes. *he availability of substitutes, thus, determines the
elasticity of demand. 6or instance, tea and coffee are substitutes. *he change in the price of
tea affects the demand for coffee. %ence, the demand for coffee and tea is elastic.
3umber of 1ses) Elasticity of demand for any commodity depends on its number of uses.
+emand is elastic@ if a commodity has more uses and inelastic if it has only one use. As coal
has multiple uses, if its price falls it will be demanded more for cooking, heating, industrial
purposes etc. (ut if its price rises, minimum will be demanded for every purpose.
$ostponement) +emand is more elastic for goods the use of which can be postponed. 6or
e!ample, if the price of silk rises, its consumption can be postponed. *he demand for silk is,
therefore, elastic. +emand is inelastic for those goods the use of which is urgent and,
therefore, cannot be postponed. *he use of medicines cannot be put off. %ence, the demand
for medicines is inelastic.
0aw aterials and 6inished -oods) *he demand for raw materials is inelastic but the
demand for finished goods is elastic. 6or instance, raw cotton has inelastic demand but cloth
has elastic demand. 'n the same way, petrol has inelastic demand but car itself has only
elastic demand.
$rice :evel) *he demand is elastic for moderate prices but inelastic for lower and higher
prices. *he rich and the poor do not bother about the prices of the goods that they buy. 6or
e!ample, rich buy (anaras silk and diamonds etc. at any price. (ut the poor buy coarse rice,
cloth etc. whatever their prices are.
'ncome :evel) *he demand is inelastic for higher and lower income groups and elastic for
middle income groups. *he rich people with their higher income do not bother about the
price. *hey may continue to buy the same amount whatever the price. *he poor people with
lower incomes buy always only the minimum re/uirements and, therefore, they are induced
neither to buy more at a lower price nor less at a higher price. *he middle income group is
sensitive to the change in price. *hus, they buy more at a lower price and less at higher
price.
Measurement of price elasticit- of %eman%
*here are five methods to measure the price elasticity of demand)
*otal E!penditure ethod) According to this method, elasticity of demand can be measured
by considering the change in price and the subse/uent change in the total /uantity of goods
purchased and the total amount of money spend on it.
*otal ;utlay N $rice ! Iuantity +emanded.
*here are three possibilities)
a. 'f with a fall in price (demand increases) the total e!penditure increases or with a rise
in price (demand falls) the total e!penditure falls, in that case the elasticity of demand
is greater than one i.e. (Ed O2.)
b. 'f with a rise or fall in the price (demand falls or rises respectively), the total
e!penditure remains the same, the demand will be unitary elastic i.e. (Ed N 2).
c. 'f with a fall in price (+emand rises), the total e!penditure also falls, and with a rise in
price (+emand falls) the total e!penditure also rises, the demand is said to be less
elastic or elasticity of demand is less than one i.e. (Ed P2).
*he method of total e!penditure has been e!plained with the help of table)
Price Quantity Demanded (Q) "otal #utlay $lasticity of demand($
d
)
2Q 2 2Q
K 4 2?
E
d
O2
? 5 47
> 7 4?
= < 5Q
E
d
N 2
< = 5Q
7 > 4?

5 ? 47
E
d
P 2
4 K 2?
2 2Q 2Q
'n the above *able, we find three possibilities)
2. ore Elastic +emand) 9hen price is 0s. 2Q the /uantity demanded is 2 unit and total
e!penditure is 2Q. 3ow price falls from 0s. 2Q to 0s. =, the /uantity demanded increases
from 2 to < units and correspondingly the total e!penditure increases from 0s. 2Q to 0s. 5Q.
*hus it is clear that with the fall in price, the total e!penditure increases and vice8 versa. .o
elasticity of demand is greater than one or E
d
O 2.
4. 1nitary Elastic +emand) 'f price is 0s. =, demand is < units so the total outlay is 0s. 5Q.
3ow price falls to 0s. <, the demand increases to = units but the total e!penditure remains
the same i.e., 0s. 5Q. *hus it is clear that with the rise or fall in price, the total e!penditure
remains the same. *he elasticity of demand in this case is e/ual to one or E
d
N 2.
5. :ess Elastic +emand) 'f price is 0s. <, demand is = and total outlay is 0s. 5Q. 3ow price
falls from 0s. < to 0e. 2. *he demand increases from = units to 2Q units and hence the total
e!penditure falls from 0s. 5Q to 0s. 2Q. *hus it is clear that with the fall in price, the total
e!penditure also falls and vice8versa. 'n this case, the elasticity of demand is less than one or
E
d
Pl.
'n the figure, total e!penditure has been shown on F8a!is and price on G8a!is. :ine **B is the total
e!penditure line. 9hen price of the commodity falls from ;$ to ;$
2
total e!penditure increases
from ;
2
to ;
4
. *he elasticity of demand is greater than one as is shown in *( portion of the
figure. 3ow, suppose that the price of the commodity decreases from ;$
2
to ;$
5
the total
e!penditure falls from ;
4
to ;. *his is shown in *B, part of the figure which represents the less
than unity elasticity of demand. 'n the same way, (, part of the figure represents the unit elasticity
of demand. *hus it is clear that the changes in total e!penditure due to changes in price also affect
the elasticity of demand.
$roportionate ethod) *his method is also associated with the name of +r. arshall.
According to this method, Cprice elasticity of demand is the ratio of percentage change in the
amount demanded to the percentage change in price of the commodity.C 't is also known as
the $ercentage ethod, 6lu! ethod, 0atio ethod, and Arithmetic ethod.
E
d
N $roportionate change in Iuantity +emanded
$roportionate change in price
Arc Elasticity of +emand) According to 9atson) CArc elasticity is the elasticity at the mid8
point of an arc of a demand curve.C
According to :eftwitch) C9hen elasticity is computed between two separate points on a
demand curve, the concept is called arc elasticity.C
,hange in demand
Arc Elasticity of +emand (EA) N ;riginal R 3ew demand
,hange in price
;riginal price R 3ew price
where)
I2 N ;riginal /uantity demanded
I4 N 3ew /uantity demanded
$2 N ;riginal price
$4 N 3ew price
0evenue ethod) A sale proceeds that a firm obtains by selling its products is called its
revenue. %owever, when total revenue is divided by the number of units sold, we get
average revenue. ;n the contrary, when addition is made to the total revenue by the sale of
one more unit of the commodity is called marginal revenue. *herefore, the formula to
measure elasticity of demand can be written as,
E
d
N A
A8
where)
E
d
N elasticity of demand
A N average revenue
N marginal revenue
INCOME E!ASTICIT$ O/ DEMAND
According to .tonier and %ague) C'ncome elasticity of demand shows the way in which a
consumerBs purchase of any good changes as a result of change in his income.C
't shows the responsiveness of a consumerBs purchase of a particular commodity to a change in his
income. 'ncome elasticity of demand means the ratio of percentage change in the /uantity demanded
to the percentage change in income.
'
e
N $roportionate change in /uantity purchased
$roportionate change in income
'
e
N $ercentage change in demand
$ercentage change in income
Degrees of Income Elasticit- of Deman%
$ositive income elasticity of +emand) $ositive income elasticity of demand is said to occur
when with the increase in the income of the consumer, his demand for goods and services
also increases and vice8versa. 'ncome elasticity of demand is positive in case of normal
goods.
'n fig. , /uantity of commodity * has been measured on F8a!is and income of the consumer
on G8a!is. ++ is the positive income elasticity of demand curve. 't slopes upward from left
to right indicating that increase in income is accompanied by increase in demand of goods
and services and vice8versa.
a. 'ncome Elasticity is 1nity) *he change in demand is proportionate to the change in
income.
b. 'ncome Elasticity -reater than ;ne) 9hen the change in demand is more than
proportionate change in income, income elasticity of demand is greater than one or
unity.
c. 'ncome Elasticity :ess than ;ne) 'f change in demand is less than proportionate change
in income, income elasticity of demand is less than one or unity.
3egative 'ncome Elasticity of +emand) 3egative income elasticity of demand is said to
occur when increase in the income of the consumers is accompanied by fall in demand of
goods and services and vice8versa. 't is the case of giffen goods.
'n fig. when income of the consumer is Q
2
, demand for goods and services is ;F. 3ow as
the income '
2
increases to '
2
/uantity demanded falls ;F to ;F
2
. Again as the income
increases to '
4
, /uantity demanded falls to ;F
4
. ++ is the negative income elasticity of
demand curve.
Sero 'ncome Elasticity of +emand) Sero income elasticity of demand is said to e!ist when
increase or decrease in income has no impact on the demand of goods and services.
'n fig. initially when income is ;', /uantity demanded is ;+. 3ow, income increases to ;'
4
demand 0emains constant i.e. ;+. Even when income reduces to Q
2
, /uantity demanded
remains ;+
-enerally, as income increases demand for goods increases. (ut in some cases, demand may
not change to change in income or demand may diminish for an increase in income. *he
former case represents "ero income elasticity. 'ncome elasticity is "ero if a change in income
fails to produce any change in demand. 'ncome elasticity is negative, if an increase in
income leads to a reduction of demand. *his happens only in the case of inferior goods. (ut
in all other cases it is positive.
'n short income elasticity is greater than one for lu!uries but less than one for necessaries.
CROSS E!ASTICIT$ O/ DEMAND

't is the ratio of proportionate change in the /uantity demanded of G to a given proportionate change
in the price of the related commodity F. 't is a measure of relative change in the /uantity demanded
of a commodity due to a change in the price of its substitute complement.
't can be e!pressed as,
,
e
N $roportionate change in the /uantity demanded of G
$roportionate change in the price of F

T-pes of Cross Elasticit- of Deman%
2. $ositive) 9hen goods are substitute of each other than cross elasticity of demanded is
positive. 'n other words, when an increase in the price of G leads to an increase in the
demand of F. 6or instance with the increase in price of a tea, demand of coffee will
increase. 'n fig 4< Iuantity has been measured on ;F a!is and price on ;G a!is. At price
;$ of G commodity, demand of F commodity is ;. 3ow as price ;f G commodity
increase to ;$
2
demand of F8commodity increases to ;
2
. *hus, cross, elasticity of
demand is positive.
4. 3egative) 'n case of complementary goods, cross elasticity of demand is negative. A
proportionate increase in price of one commodity leads to a proportionate fall in the demand,
of .another commodity because both are demanded #ointly
'n fig. /uantity has been measured on ;F8a!is while price has been measured on ;G8a!is.
9hen the price of commodity increases from ;$ to ;$
2
/uantity demanded falls from ;
to ;
2
*hus, cross elasticity of demand is negative.
5. Sero) ,ross elasticity of demand is "ero when two goods are related to each other. 6or
instance, increase in price of car does not affect the demand of cloth. *hus, cross elasticity
of demand is "ero. 't has been shown in fig. 4>
!imitations of Cross Elasticit- of Deman%
3egative ,ross Elasticity does not always mean complementarily.
,ross Elasticity of +emand is only a one8way 0elationship.
Importance of elasticit- of %eman%

1seful for (usiness) 't enables the business in general and the monopolists in particular to
fi! the price. .tudying the nature of demand the monopolist fi!es higher prices for those
goods which have inelastic demand and lower prices for goods which have elastic demand.
'n this way, this helps him to ma!imise his profit.
6i!ation of $rices) 't is very useful to fi! the price of #ointly supplied goods. 'n the case of
#oint products like paddy and straw, the cost of production of each is not known. *he price
of each is then fi!ed by its elastic and inelastic demand.
%elpful to 6inance inister) 't helps the 6inance inister to levy ta! on goods. After
levying ta!es more and more on goods which have inelastic demand, the -overnment
collects more revenue from the people without causing them inconvenience. oreover, it is
also useful for the planning.
6i!ation of 9ages) 't guides the producers to fi! wages for labourers. *hey fi! high or low
wages according to the elastic or inelastic demand for the labour.
'n the .phere of 'nternational *rade) 't is of greater significance in the sphere of
international trade. 't helps to calculate the terms of trade and the conse/uent gain from
foreign trade. 'f the demand for home product is inelastic, the terms of trade will be
profitable to the home country.
.ignificant for -overnment Economic $olicies) *he knowledge of elasticity of demand is
very important for the government in such matters as controlling of business cycles,
removing inflationary and deflationary gaps in the economy. .imilarly, for price stabili"ation
and the purchase and sale of stocks, information about elasticity of demand is most useful.
DEMAND /ORECASTIN
6uture is uncertain. *here is great deal of uncertainty with regard to demand. .ince the demand is
uncertain, production, cost, revenue, profit etc. are also uncertain. *hrough forecasting it is possible
to minimise the uncertainties.
6orecasting simply refers to estimating or anticipating future events. 't is an attempt to foresee the
future by e!amining the past. *hus demand forecasting means estimating or anticipating future
demand on the basis of past data.
O04ecti(es of Deman% /orecasting
.hort *erm ;b#ectives
a. *o help in preparing suitable sales and production policies.
b. *o help in ensuring a regular supply of raw materials.
c. *o reduce the cost of purchase and avoid unnecessary purchase.
d. *o ensure best utili"ation of machines.
e. *o make arrangements for skilled and unskilled workers so that suitable labour force
may be maintained.
f. *o help in the determination of a suitable price policy.
g. *o determine financial re/uirements.
h. *o determine separate sales targets for all the sales territories.
i. *o eliminate the problem of under or over production.
:ong term ;b#ectives
a. *o plan long term production.
b. *o plan plant capacity.
c. *o estimate the re/uirements of workers for long period and make arrangements.
d. *o determine an appropriate dividend policy.
e. *o help the proper capital budgeting.
f. *o plan long term financial re/uirements.
g. *o forecast the future problems of material supplies and energy crisis.

/actors Affecting Deman% /orecasting
6or making a good forecast, it is essential to consider the various factors governing demand
forecasting. *hese factors are summari"ed as follows.
$revailing business conditions) 9hile preparing demand forecast it becomes necessary to
study the general economic conditions very carefully. *hese include the price level changes,
change in national income, per8capita income, consumption pattern, savings and investment
habits, employment etc.
,onditions within the industry) Every business enterprise is only a unit of a particular
industry. .ales of that business enterprise are only a part of the total sales of that industry.
*herefore, while preparing demand forecasts for a particular business enterprise, it becomes
necessary to study the changes in the demand of the whole industry, number of units within
the industry, design and /uality of product, price policy, competition within the industry etc.
,onditions within the firm) 'nternal factors of the firm also affect the demand forecast.
*hese factors include plant capacity of the firm, /uality of the product, price of the product,
advertising and distribution policies, production policies, financial policies etc.
6actors affecting e!port trade) 'f a firm is engaged in e!port trade also it should consider the
factors affecting the e!port trade. *hese factors include import and e!port control, terms and
conditions of e!port, e!im policy, e!port conditions, e!port finance etc.
arket behaviour) 9hile preparing demand forecast, it is re/uired to consider the market
behavior which brings about changes in demand.
.ociological conditions) .ociological factors have their own impact on demand forecast of
the company. *hese conditions relate to si"e of population, density, change in age groups,
si"e of family, family life cycle, level of education, family income, social awareness etc.
$sychological conditions) 9hile estimating the demand for the product, it becomes
necessary to take into consideration such factors as changes in consumer tastes, habits,
fashions, likes and dislikes, attitudes, perception, life styles, cultural and religious bents etc.
,ompetitive conditions) *he competitive conditions within the industry may change.
,ompetitors may enter into market or go out of market. A demand forecast prepared without
considering the activities of competitors may not be correct.
#rocess of Deman% /orecasting5 Steps in Deman% /orecasting
2. +etermine the purpose for which forecasts are used.
4. .ubdivide the demand forecasting programme into small ' parts on the basis of product or
sales territories or markets.
5. +etermine the factors affecting the sale of each product and their relative importance.
7. .elect the forecasting methods.
<. .tudy the activities of competitors.
=. $repare preliminary sales estimates after, collecting necessary data.
>. Analyse advertisement policies, sales promotion plans, personal sales arrangements etc. and
ascertain how far these programmes have been successful in promoting the sales.
?. Evaluate the demand forecasts monthly, /uarterly, half yearly or yearly and necessary
ad#ustments should be done.
K. $repare the final demand forecast on the basis of preliminary forecasts and the results of
evaluation.
Met'o%s of %eman% forecasting
*here are several methods to predict the future demand. All methods can be
broadly classified into two)
.urvey methods) 1nder this method surveys are conducted to collect information about the
future purchase plans of potential consumers. .urvey methods help in obtaining information
about the desires, likes and dislikes of consumers through collecting the opinion of e!perts
or by interviewing the consumers. .urvey methods are used for short term forecasting.
'mportant survey methods are)
2. ,onsumersB interview method (,onsumers survey)) 1nder this method, consumers are
interviewed directly and asked the /uantity they would like to buy. After collecting the
data, the total demand for the product is calculated. *his is done by adding up all
individual demands. 1nder the consumer interview method, either all consumers or
selected few are interviewed. 9hen all the consumers are interviewed, the method is
known as complete enumeration method. 9hen only a selected group of consumers are
interviewed, it is known as sample survey method
Advantages
a. 't is a simple method because it is not based on past record.
b. 't suitable for industrial products.
c. *he results are likely to be more accurate.
d. *his method can be used for forecasting the demand of a new product.
+isadvantages
a. 't is e!pensive and time consuming.
b. ,onsumers may not give their secrets or buying plans.
c. *his method is not suitable for long term forecasting.
d. 't is not suitable when the number of consumer is large.
4. ,ollective opinion method) 1nder this method the salesmen estimate the e!pected sales
in their respective territories on the basis of previous e!perience. *hen demand is
estimated after combining the individual forecasts (sales estimates) of the salesmen.
*his method is also known as sales force opinion method.
Advantages
a. *his method is simple.
b. 't is based on the first hand knowledge of .alesmen.
c. *his method is particularly useful for estimating demand of new products.
d. 't utilises the specialised knowledge of salesmen who are in close touch with the
prevailing market conditions.
+isadvantages
a. *he forecasts may not be reliable if the salespeople are not trained.
b. 't is not suitable for long period estimation.
c. 't is not fle!ible.
d. .alesmen may give lower estimates that make possible easy achievement of sales
/uotas fi!ed for each salesman.
5. E!pertsB opinion method) *his method was originally developed at 0and ,orporation in
2K<Q by ;laf %elmer, +alkey and -ordon. 1nder this method, demand is estimated on
the basis of opinions of e!perts and distributors other than salesmen and ordinary
consumers. *his method is also known as +elphi method. +elphi is the ancient -reek
temple where people come and prey for information about their future.
Advantages
a. 6orecast can be made /uickly and economically
b. *his is a reliable method because estimates are made on the basis of knowledge
and e!perience of sales e!perts.
c. *he firm need not spare its time on preparing estimates of demand.
d. *his method is suitable for new products.
+isadvantages
a. *his method is e!pensive.
b. *his method sometimes lacks reliability
7. ,onsumer clinics) 'n this method some selected buyers are given certain amounts of
money and asked to buy the products. *hen the prices are changed and the consumers
are asked to make fresh purchases with the given money. 'n this way the consumersC
responses to price changes are observed. *hus the behaviour of the consumers is
studied.
;n this basis demand is estimated. *his method is an improvement over consumerBs interview
method.
erits
a. 't provides an opportunity to study the behaviour of consumers directly.
b. 't provides reliable and realistic picture about future demand.
c. 't gives useful information to aid in the decision making process.
+emerits
a. 't is a time consuming method.
b. .electing the participants is very difficult.
c. 't is e!pensive.
d. ,onsumers may take it as a game. *hey may not reveal their preferences.
<. End use method) *his method is based on the fact that a product generally has different
uses. 'n the end use method, first a list of end users (final consumers, individual
industries, e!porters etc.) is prepared. *hen the future demand for the product is found
either directly from the end users or indirectly by estimating their future growth. *hen
the demand of all end users of the product is added to get the total demand for the
product.
.tatistical ethods) .tatistical methods use the past data as a guide for knowing the level of
future demand. .tatistical methods are generally used for long run forecasting. *hese
methods are used for established products.
.tatistical methods include)
2. *rend pro#ection method) 6uture sales are based on the past sales, because future is the
grand8child of the past and child of the present. 1nder the trend pro#ection method
demand is estimated on the basis of analysis of past data. *his method makes use of
time series (data over a period of time). 9e try to ascertain the trend in the time series.
*he trend in the time series can be estimated by using any one of the following four
methods)
a. :east8s/uare method
b. 6ree8hand method
c. oving average method
d. .emi8average method.
4. 0egression and ,orrelation) *hese methods combine economic theory and statistical
techni/ue of estimation. 1nder these methods the relationship between the sales
(dependent variable) and other variables (independent variables such as price of related
goods, income, advertisement etc.) is ascertained. .uch relationship established on the
basis of past data may be used to analyse the future trend. *he regression and
correlation analysis is also called the econometric model building.
5. E!trapolation) 1nder this statistical method, the future demand can be e!trapolated by
applying (inomial e!pansion method. *his method is used on the assumption that the
rate of charge in demand in the past has been uniform.
7. .imultaneous e/uation method) *his involves the development of a complete
econometric model which can e!plain the behaviour of all the variables which the
company can control. *his method is not very popular.
<. (arometric techni/ue) *his is an improvement over the trend pro#ection method.
According to this techni/ue the events of the present can be used to predict the
directions of change m the future. %ere certain economic and statistical indicators from
the selected time series are used to predict variables. $ersonal income, non8agricultural
placements, gross national income, prices of industrial materials, wholesale commodity
prices, industrial production, bank deposits etc. are some of the most commonly used
indicators.
Advantages of .tatistical ethods
a. *he method of estimation is scientific
b. Estimation is based on the theoretical relationship between sales (dependent variable)
and price, advertising, income etc. (independent variables)
c. *hese are less e!pensive.
d. 0esults are relatively more reliable.
+isadvantages of .tatistical ethods
a. *hese methods involve complicated calculations.
b. *hese do not rely much on personal skill and e!perience.
c. *hese methods re/uire considerable technical skill and e!perience in order to be
effective.
Met'o%s of Deman% /orecasting for Ne& #ro%ucts
+emand forecasting of new product is more difficult than forecasting for e!isting product. *he
reason is that the product is not available. %ence, no historical data are available. 'n these conditions
the forecasting is to be done by taking into consideration the inclination and wishes of the customers
to purchase.
*he following methods for forecasting demand of new products)
Evolutionary approach) *his method is based on the assumption that the new product is the
improvement and evolution of the old product. *he demand is forecasted on the basis of the
demand of the old product. 6or e!ample, the demand for black and white *A should be
taken in to consideration while forecasting the demand for colour *A sets because the latter
is an improvement of the former.
.ubstitute approach) %ere the new product is treated as a substitute of an e!isting product,
e.g. polythene bags for cloth bags. *hus the demand for a new product is analysed as a
substitute for some e!isting goods or service.
-rowth curve approach) 1nder this method the growth rate of demand of a new product is
estimated on the basis of the growth rate of demand of an e!isting product. .uppose $ears
soap is in use and a new cosmetic is to be introduced in the market. 'n this case the average
sale of $ears soap will give an idea as to how the new cosmetic will be accepted by the
consumers.
;pinion poll approach) 1nder this method the demand for a new product is estimated on the
basis of information collected from the direct interviews (survey) with consumers.
.ales E!perience approach) 1nder this method, the new product is offered for sale in a
sample market, i.e. by direct mail or through multiple shop or departmental shop. 6rom this
the total demand is estimated for the whole market.
Aicarious approach) *his method consists of surveying consumersB reactions through the
specialised dealers who are in touch with consumers. *he dealers are able to know as to how
the customers will accept the new product. ;n the basis of their reports demand can be
estimated. *he above methods are not mutually e!clusive. 't is de desirable to use a
combination of two or more methods in order to get better results.


COST CONCE#TS
Various Concepts of Costs
A managerial economist must have a proper understanding of the different cost concepts which are
essential for clear business thinking. *he several alternative bases of classifying cost and the
relevance of each for different kinds of problems are to be studied. *he various relevant concepts of
costs used in business decisions are given below.
*otal ,ost) *otal cost is the total cash payment made for the input needed for production. 't
may be e!plicit or implicit is the sum total of the fi!ed and variable costs.
Average ,ost) Average cost is the cost per unit of output. 't is obtained by dividing the total
cost (*,) by the total /uantity produced (I)
Average ,ost N *,
I
arginal ,ost) arginal cost is the additional cost incurred to produce an additional unit of
output. ;r it is the cost of the marginal unit produced.
$%ample&
A company produces 2QQQ typewriters per annum. *otal fi!ed cost is 0s. 2,QQ,QQQ per annum. +irect
material cost per typewriter is 0s. 4QQ and direct labour cost 0s. 2QQ. Aariable cost per typewriter N
direct material R direct labour
N 4QQ R 2QQ N 0s. 5QQ
*otal variable cost (2QQQ!5QQ) N 0s.5QQQQQ
6i!ed ,ost N 0s. 2QQQQQ
*otal cost N 0s.7QQQQQ
*, N 0s. 7QQQQQ
A, N 7QQQQQ
2QQQ
N 0s. 7QQ

'f output is increased by one typewriter, the cost will appear as follows)
*otal variable cost (2QQ2!5QQ) N 5QQ5QQ
6i!ed cost N 2QQQQQ
*otal N 7QQ5QQ
%ere the additional cost incurred to produce the 2QQ2typewriter is 0s.5QQ
(7QQ5QQ 8 7QQQQQ). *herefore, the marginal cost per typewriter is 0s.5QQ.

/i*e% an% Varia0le Costs
*his classification is made on the basis of the degree to which they vary with the changes in
volume. 6i!ed cost is that cost which remains constant up to a certain level of output. 't is
not affected by the changes in the volume of production. *hen fi!ed cost per unit aries with
output rate. 9hen the production increases, fi!ed cost per unit decreases.
6i!ed cost includes salary paid to administrative staff, depreciation of fi!ed assets, rent of
factory etc. *hese costs are fi!ed in the sense that they do not change in short8run.
Aariable cost varies directly with the variation in output. An increase in total output results
in an increase in total variable costs and decrease in total output results in a proportionate
decline in the total variable costs. *he variable cost per unit will be constant. Aariable costs
include the costs of all inputs that vary with output like raw materials, running costs of fi!ed
assets such as fuel, ordinary repairs, routine maintenance e!penditure, direct labour charges
etc.
*he distinction of cost is important in forecasting the effect of short8run changes in volume upon
costs and profits.
S'ort6Run an% !ong6Run Costs
*his cost distinction is based on the time element. .hort80un is a period during which the
physical capacity of the firm remains fi!ed. Any increase in output during this period is
possible only by using the e!isting physical capacity more intensively.
:ong80un is a period during which it is possible to change the firmBs physical capacity. All
the inputs become variable in the long8term.
.hort80un cost is that which varies with output when the physical capacity remains constant.
:ong80un costs are those which vary with output when all the inputs are variable.
.hort80un costs are otherwise called variable costs. A firm wishing to change output /uickly
can do it only by increasing the variable factors. .hort8 0un cost concept helps the manager
to take decision when a firm has to decide whether or not to produce more or less with a
given plant.
:ong80un cost analysis helps to take investment decisions. :ong80un increase in output
may necessitate installation of more capital e/uipment.
Opportunit- Costs an% Outla- Costs
*his distinction is made on the basis of the nature of the sacrifice made.
;utlay costs are those e!penses which are actually incurred by the firm. *hese are the actual
payments made for labour, material, plant, building, machinery, traveling, transporting etc.
*hese are the e!pense items that appear in the books of accounts.
;utlay cost is an accounting cost concept. 't is also called absolute cost or actual cost.
9henever the inputs are to be bought for cash the outlay concept is to be applied.
A businessman chooses and investment proposal from different investment opportunities. (efore
taking the decision he has to compare all the opportunities and choose the best. 9hen he chooses the
best he sacrifices the possibility of making profit from other investment opportunities. *he cost of
his choice is the return that he could have earned from other investment opportunities he has given
up or sacrificed. A businessman decides to use his own money to buy a machine for the business.
*he cost of that money is the probable return on the money from the ne!t most acceptable
alternative
investment. 'f he invested the money at 24 percent interest, the opportunity cost of investing in its
own business would be the 24 percent interest he has forgone.
;pportunity cost concept is useful for taking short8rum decisions also.

;pportunity cost is the cost concept to use when the supply of inputs is strictly limited.

'nvestment decision involves opportunity costs measurable in terms of sacrificed income
from alternative investments.
*he opportunity cost of any action is measured by the value of the most favorable
alternative course which has to be foregone if that action is taken.
;pportunity cost arises only when there is an alternative. 'f there is no alternative,
opportunity cost is the estimated earnings of the ne!t best use.
*his concept is of very great use in managerial decision8making.
Out6of6poc7et an% Boo7 Costs
;ut8of8pocket costs are those costs that involve current cash payment. 9ages, rent, interest etc., are
e!amples of this. *he out8of8pocket costs are also called e!plicit costs.
(ook costs do not re/uire current cash e!penditure. 1npaid salary of the owner manager,
depreciation, and unpaid interest cost of ownerBs own fund are e!amples of book costs. (ook costs
may be called implicit costs. (ut the book costs are taken into account in determining the legal
dividend payable during a period. (ook cost is the cost of self owned factors of production. *he
book cost can be converted into out8of8pocket cost.
(oth book costs and out8of8pocket costs are considered for all decisions.
*he distinction is very helpful in taking li/uidity decisions.
Incremental an% Sun7 costs
'ncremental ,ost) 'ncremental cost is the additional cost due to a change in the level or
nature of business activity. *he change may be caused by adding a new product, adding new
machinery, replacing machinery by a better one etc. 'ncremental or differential cost is not
marginal cost. arginal cost is the cost of an added (marginal) unit of output. 'ncremental
cost helps management to evaluate the alternatives. 'ncremental cost will be different in the
case of different alternatives.
.unk costs) .unk costs are those which are not altered by any change. *hey are the costs
incurred in the past. *his cost is the result of past decision, and cannot be changed by future
decisions. ;nce an asset has been bought or an investment made, the funds locked up
represent sunk costs. As these costs do not alter when any change in activity is made they
are sunk and are irrelevant to a decision being taken now. 'nvestments in fi!ed assets are
e!amples of sunk costs. As soon as fi!ed assets have been installed, their cost is sunk. .unk
cost, on the other hand, will remain the same irrespective of the alternative selected.
E*plicit an% Implicit or Impute% costs
E!plicit ,osts) E!plicit costs are those e!penses that involve cash payments. *hese are the
actual or business costs that appear in the books of accounts. E!plicit cost is the payment
made by the employer for those factors of production hired by him from outside. *hese costs
include wages and salaries paid payments for raw materials, interest on borrowed capital
funds, rent on hired land, ta!es paid to the government etc.
'mplicit ,osts) 'mplicit costs are the costs of the factor units that are owned by the employer
himself.
o 't does not involve cash payment and hence does not appear in the books of
accounts.
o *hese costs did not actually incur but would have incurred in the absence of
employment of self8owned factors of production. *he two normal implicit costs are
depreciation and return on capital contributed by shareholders.
o 'n small scale business unit the entrepreneur himself acts as the manager of the
business. 'f he were employed in another firm he would be given salary. *he salary
he has thus forgone is the opportunity cost of his services utilised in his own firm.
*his is an implicit cost of his business.
o 'mplicit costs are not considered for finding out the loss or gains of the business, but
help a lot in business decisions.
ECONOMIES O/ SCA!E
*he term CeconomiesC refers to cost advantage. Economies of scale refer to advantages of large scale
production. 't is classified into two8 internal economies and e!ternal economies.
+iseconomies are the disadvantages which a faces when the scale of production is e!panded beyond
a certain level diseconomies may be of two types8 internal and e!ternal diseconomies.
Internal Economies an% Diseconomies
9e saw that returns to scale increase in the initial stages and after remaining constant for a
while, they decrease. *he /uestion arises as to why we get increasing returns to scale due to
which cost falls and why after a certain point we get decreasing returns to scale due to which
cost rises. *he answer is that initially a firm en#oys internal economies of scale and beyond a
certain limit it suffers from internal diseconomies of scale. 'nternal economies and
diseconomies are of following main kinds)
a) *echnical economies and diseconomies) :arge8scale production is associated with
technical economies. As the firm increases its scale of operations, it becomes possible
to use more specialised and efficient form of all factors, specially capital e/uipment
and machinery. 6or producing higher levels of output, there is generally available a
more efficient machinery which when employed to produce a large output yields a
lower cost per unit of output. .econdly, when the scale of production is increased and
the amount of labour and other factors become larger, introduction of a greater degree
of division of labour or specialisation becomes possible and as a result cost per unit
declines.
%owever, beyond a certain point a firm e!periences net diseconomies of scale. *his
happens because when the firm has reached a si"e large enough to allow utili"ation of
almost all the possibilities of division of labour and the employment of more efficient
machinery, further increase in the si"e of the plant will bring high long8run cost
because of difficulties of management. 9hen the scale of operations becomes too large,
it becomes difficult for the management to e!ercise control and to bring about proper
coordination.
b) anagerial economies and diseconomies) anagerial economies refer to reduction in
managerial cost. 9hen output increases, division of labour can be applied to
management. *he production manager can look after production, sales manager can
look after sales, finance manager can look after finance department. 'f scale of
production increases further, each department can be further sub8divided for e.g. sales
can be split into sections for advertising e!ports and customer service.
.ince individual activities come under the supervision of specialists, managementBs
efficiency and productivity greatly improve. +ecentralisation of decision making
authority also becomes possible in such a firm which enhances further the efficiency
and productivity of managers. *hus specialisation of management enables large firms
to achieve reduction in managerial costs.
%owever, as scale of production increases beyond a certain limit, managerial
diseconomies set in. anagement finds it difficult to e!ercise control and bring
coordination among various departments. *he managerial structure becomes more
comple! and is affected by more bureaucracy, more red tape, lengthening of
communication lines and so on. All these affect the efficiency and productivity of
management and the firm itself.
c) ,ommercial economies and diseconomies) $roduction of big volumes of goods
re/uires large amount of material and components. *his enables the firm to place a
bulk order for materials and components and en#oy lower prices for them. Economies
can also be achieved in selling the product. 'f the sales staff is not being worked to
capacity, additional output can be sold at little e!tra cost. oreover, large firms can
benefit from economies of advertising. As scale of production increases, advertising
costs per unit of output fall. 'n addition, a large firm may also be able to sell its by8
products8something which might be unprofitable for a small firm.
*hese economies become diseconomies after an optimum scale. 6or e!ample,
advertisement e!penditure and other marketing overheads will increase more than
proportionately after the optimum scale.
d) 6inancial economies and diseconomies) 'n raising finance for e!pansion large firm is in
favorable position. 't can, for instance, offer better security to bankers and, because it is
well8known, raise money at lower cost, since investors have confidence in it and prefer
shares which can be readily sold on the stock e!change.
%owever, these financial costs will rise more proportionately after the optimum scale
of production. *his may happen because of relatively more dependence on e!ternal
finances.
e) 0isk bearing economies and diseconomies) 't is said that a large business with diverse
and multi8production capability is in a better position to withstand economic ups and
downs, and therefore, en#oys economies of risk bearing.
%owever, risk may increase if diversification instead of giving a cover to economic
disturbances increases these.
E*ternal Economies an% Diseconomies
E!ternal economies and diseconomies are those economies and diseconomies which accrue
to firms as a result of e!pansion in the output of whole industry and they are not dependent
on the output level of individual firms. *hey are e!ternal in the sense they accrue to firms
not out of their internal situation but from outside i.e. e!pansion of the industry. *hese are
available to one or more of the firms in the form of)
a) ,heaper raw materials and capital e/uipment) *he e!pansion of an industry may
result in e!ploration of new and cheaper sources of raw material, machinery and other
types of capital e/uipment. E!pansion of an industry results in greater demand for the
various kinds of materials and capital e/uipment re/uired by it. *his makes it possible
to purchase on a large scale from other industries. *his reduces their cost of production
and hence their prices. *hus, firms using these materials and capital e/uipment will be
able to get them at a lower price.
b) *echnological e!ternal economies ) 9hen the whole industry e!pands, it may result in
the discovery of new technical knowledge and in accordance with that the use of
improved and better machinery than before. *his will change the technical co8efficient
of production and will enhance productivity of firms in the industry and reduce their
cost of production.
c) +evelopment of skilled labour ) 9hen an industry e!pands in an area the labour in that
area is well accustomed to do the various productive processes and learns a good deal
from the e!perience. As a result, with the growth of an industry in an area a pool of
trained labour is developed which has a favorable effect on the level of productivity
and cost of the firms in that industry.
d) -rowth of ancillary industries) 9ith the growth of an industry, a number of ancillary
industries may specialise in production of raw materials, tools and machinery etc. *hey
can provide them at a lower price to the main industry. :ikewise, some firms may get
developed processing the waste products of the industry and making out some useful
product out of it. *his will tend to reduce the cost of production in general.
e) (etter transportation and marketing facilities) *he e!pansion of an industry resulting
from entry of new firms may make possible the development of transportation and
marketing network to a great e!tent which will greatly reduce cost of production of the
firms. .imilarly, communication system may get modernised resulting in better and
speedy information.
COST6OUT#UT RE!ATIONS
*he cost8output relationship plays an important role in determining the optimum level of production.
Lnowledge of the cost8output relation helps the manager in cost control, profit prediction, pricing,
promotion etc. *he relation between cost and output is technically described as the cost function.
*, N f(I)
9here,
*, N *otal cost
I N Iuantity produced
f N 6unction
*he cost function can be classified as)
.hort8run ,ost8;utput 0elation
*he cost concepts made use of in the cost behavior are total cost, average cost and marginal
cost. *otal cost if the actual money spent to produce a particular /uantity of output. 't is the
summation of fi!ed and variable costs.
*, N *6, R *A,
1pto a certain level of production total fi!ed cost, i.e. the cost of plant, building, e/uipment
etc. remains fi!ed. (ut the total variable costs i.e., the cost of labour, raw materials etc. vary
with the variation in output
A, N *,
I
;r total of average fi!ed cost N (*6, D I) and average variable cost N (*A,DI)
arginal cost is the addition to the total cost due to the production of an additional unit of
product. ;r it is the cost of the marginal unit produced. 't can be arrived at by dividing the
change in total cost by the change in total output.
, N *,
I
'n the short8run there will not be any change in total fi!ed cost. %ence change in total cost
implies change in total variable cost only.
.hort8run ,ost8;utput 0elations

Q "FC "'C "C ('C (FC (C C
Q =Q 8 =Q 8 8 8 8
2 =Q 4Q ?Q 4Q =Q ?Q 4Q
4 =Q 5= K= 2? 5Q 7? 2=
5 =Q 7? 2Q? 2= 4Q 5= 24
7 =Q =7 247 2= 2< 52 2=

< =Q KQ 2<Q 2? 24 5Q 4=
= =Q 254 2K4 44 2Q 54 74
*he relationship between AA,, A*, and A6, can be summed up as follows)
2. 'f both A6, and AA, fall, A, will also fall because A,NA6,RAA,
4. 9hen A6, falls and AA, rises,
a) A, will fall where the drop in A6, is more than the rise in AA,.
b) A, remains constant if the drop in A6,Nrise in AA,.
c) A, will rise where the drop in A6, is less than the rise in AA,.
:ong80un ,ost8;utput 0elations
*he long8run cost8output relations imply the relationship between total costs and total
output. As the change in production in the long8 run is possible by changing the scale of
production, the long8run cost8output relationship is influenced by the law of returns to scale.
'n the long8run a firm has a number of alternatives in regard to the scale of operations. 6or
each scale of production or plant si"e, the firm has a separate short8run average cost curve.
%ence the long8run average cost curve is composed of a series of,
.hort8run average cost curves
A short8run average cost (.A,) curve applies to only one plant whereas the long8 run average cost
(:A,) curve takes into consideration many plants. At any one time the firm has only one si"e of
plant. *hat plant remains fi!ed during that period. Any increase in production in that period is
possible only with that plant capacity. *hat plant has a corresponding average cost (.A,) curve. (ut
in a long period the firm can move from one plant si"e to another. Each plant has its corresponding
.A, curve.

*he long8run cost8output relationship is shown graphically by the :A, curve. *o draw an :A,
curve we have to start with a number of .A, curves. 'n the fig. <.5 we have assumed that there are
only three si"es of plants8small, medium and large, .A,# refers to the average cost curve for the
small plant, . A,, for the medium si"e plant and.A,5 for the large si"e plant. 'f the firm wants to
produce ;$ units or less, it will choose the small plant. 6or an output beyond ;I the firm will opt
for medium si"e plant. Even if an increased production is possible with small plant production
beyond ;I will increase cost of production per unit. 6or an output ;0 the firm will choose the large
plant. *hus in the long8run the firm has a series of .A, curves. *he :A, curve drawn will be
tangential to the three .A, curves i.e. the :A, curve touches each .A, curve at one point. *he
:A, curve is also known as Envelope ,urve as it envelopes all the .A, curves. 3o point on any of
the :A, curve can ever be below the :A, curve. 't is also known as $lanning ,urve as it serves as
a guide to the entrepreneur
'n his planning the si"e of plant for future e!pansion. *he plant which yields the lowest average cost
of production will be selected. :A, can, therefore, be defined as the lowest possible average cost of
producing any output, when the management has ade/uate ' time to make all desirable changes and
ad#ustments.
'n the long8run the demand curve of the firm depends on the law of returns to scale. *he law of
returns to scale states that if a firm increases the /uantity of all inputs simultaneously and
proportionately, the total output initially increases more than proportionately but eventually
increases less than proportionately. 't implies that when production increases, per unit cost firstB
decreases but ultimately increases. *his means :A, curve falls initially and rises subse/uently. :ike
.A, curve :A, curve also is 18 shaped, but it will be always flatter then .A, curves. *he 18shape
implies lower and lower average cost in the beginning until the optimum scale of the firm is reached
and successively higher average cost thereafter. *he increasing return is e!perienced on account of
the economies of scale or advantages of large8scale production 'ncrease in scale makes possible
increased division and peciali"ation of labour and more efficient use of machines. After a certain
point increase in production makes management more difficult and less efficient resulting in less
than proportionate increase in output
:ong8run arginal ,ost ,urve

*he long8run marginal cost curve represents the cost of an additional unit of output when all the
inputs vary. *he long8run marginal cost curve (:,) is derived from the short8run marginal cost
(.,) curves. :, curve intersects :A, curve at its minimum point ,. *here is only one plant
si"e whose minimum .A, coincides with the minimum :A, and :,.
.A,
4
N .,
4
N :A, N :,
*he point , indicates also the optimum scale of production of the firm in the long8run or optimum
output. ;ptimum output level is the level of production at which the cost of production per unit, i.e.
A,, is the lowest. *he optimum level is not the ma!imum profit level. *he optimum point is where
A,N,. %ere , is the optimum point.
#RODUCTION ANA!$SIS
#ro%uction
$roduction is the conversion of input into output. *he factors of production and all other things
which the producer buys to carry out production are called input. *he goods and services produced
are known as output. *hus production is the activity that creates or adds utility and value.
'n the words of 6raser, C'f consuming means e!tracting utility from matter, producing means
creating utility into matterC.
According to Edwood (uffa, C$roduction is a process by which goods and services are createdC
/actors of #ro%uction
As already stated, production is a process of transformation of factors of production (input) into
goods and services (output). *he factors of production may be defined as resources which help the
firms to produce goods or services. 'n other words, the resources re/uired to produce a given product
are called factors of production. $roduction is done by combining the various factors of production.
:and, labour, capital and organisation (or entrepreneurship) are the factors of production (according
to arshall). 9e can use the word ,E:: to help us remember the four factors of production) ,.
capital@ Entrepreneurship@ : land) and : labour.
C'aracteristics of /actors of #ro%uction
*he ownership of the factors of production is vested in the households.
*here is a basic distinction between factors of production and factor services. 't is these
factor services, which are combined in the process of production.
*he different units of a factor of production are not homogeneous. 6or e!ample, different
plots of land have different level of fertility. .imilarly labourers differ in efficiency.
6actors of production are complementary. *his means their co8operation or combination is
necessary for production.
*here is some degree of substitutability between factors of production. 6or e!ample, labour
can be substituted for capital to a certain e!tent.

#ro%uction /unction
$roduction is the process by which inputs are transformed in to outputs. *hus there is relation
between input and output. *he functional relationship between input and output is known as
production function. *he production function states the ma!imum /uantity of output which can be
produced from any selected combination of inputs. 'n other words, it states the minimum /uantities
of input that are necessary to produce a given /uantity of output.
*he production function is largely determined by the level of technology. *he production function
varies with the changes in technology. 9henever technology improves, a new production function
comes into e!istence. *herefore, in the modern times the output depends not only on traditional
factors of production but also on the level of technology.
*he production function can be e!pressed in an e/uation in which the output is the dependent
variable and inputs are the independent variables. *he e/uation is e!pressed as follows)
IN f (:, L, *...............n)
9here,
I N output
: N labour
L N capital
* N level of technology
3 N other inputs employed in production.
*here are two types of production function)
a. .hort run production function) 'n the short run production function the /uantity of only one
input varies while all other inputs remain constant.
b. :ong run production function) 'n the long run production function all inputs are variable.
Assumptions of #ro%uction /unction
*he production function is based on the following assumptions)
*he level of technology remains constant.
*he firm uses its inputs at ma!imum level of efficiency.
't relates to a particular unit of time.
A change in any of the variable factors produces a corresponding change in the output.
*he inputs are divisible into most viable units.
Managerial Use of #ro%uction /unction
*he production function is of great help to a manager or business economist. *he managerial uses of
production function are outlined as below)
't helps to determine least cost factor combination) *he production function is a guide to the
entrepreneur to determine the least cost factor combination. $rofit can be ma!imi"ed only by
minimi"ing the cost of production. 'n order to minimi"e the cost of production, inputs are to
be substituted. *he production function helps in substituting the inputs.
't helps to determine optimum level of output) *he production function helps to determine
the optimum level of output from a given /uantity of input. 'n other words, it helps to arrive
at the producerBs e/uilibrium.
't enables to plan the production) *he production function helps the entrepreneur (or
management) to plan the production.
't helps in decision8making) $roduction function is very useful to the management to take
decisions regarding cost and output. 't also helps in cost control and cost reduction.
'n short, production function helps both in the short run and long run decision8making process.
Co00 Douglas #ro%uction /unction
$aul %. +ouglas and ,.9 ,obb of the 1...A have studied the production of the
American manufacturing industries and they formulated a statistical production function.
't is popularly known as ,obb8+ouglas $roduction 6unction. 't is stated as follows.
I N L:a,,,a)
where,
I N output
: N /uantity of labour
, N /uantity of capital
L and a N positive constants
'n this production function the output (I) is a function of two inputs : and ,.
According to ,obb +ouglas production function, about 5D7 of the increase in
output is due to labour and the remaining 2D7 is due to capital. ;n this basis,
,obb +ouglas production function can be e!pressed as under)
I N L:
5D7
,
2D7
:R, N 5 R 2 N 2
7 7
An important point in ,obb +ouglas production function is that it indicates constant returns to scale.
*his means that if each input factor is increased by one percent, output will e!actly increase by one
percent. 'n other words, there will be no economies or diseconomies of scale.
Although the ,obb +ouglas production function is nonlinear, it can be transformed into a linear
function by converting all variables into logarithms. *hat is why this function is known as a log
linear function.
Importance of Co006Douglas #ro%uction /unction
,obb8+ouglas production function is most commonly used function in the field of economics. 't
graduates data on output and input well. any economists used it independently. %ence, there are a
number of varieties of the ,obb8+ouglas form which yield variable elasticityBs of production and
substitution. 't is useful in international or inter8industry comparisons.
,obb8+ouglaBs research has been a test of the marginal productivity theory of wages (or theory of
distribution) as well as descriptions of production technology.

!A,S O/ #RODUCTION
!A, O/ DIMINIS"IN RETURN or !A, O/ VARIAB!E #RO#ORTION
*he law of variable proportion shows the production function with one input factor variable while
keeping the other input factors constant.
*he law of variable proportion states that, if one factor is used more and more (variable), keeping the
other factors constant, the total output will increase at an increasing rate in the beginning and then at
a diminishing rate and eventually decreases absolutely.
According to L. E. (oulding, CAs we increase the /uantity of any one input which is combined with
a fi!ed /uantity of the other inputs, the marginal physical productivity of the variable input must
eventually declineC.
'n this law we study the effect of variations in factor proportion on output. 9hen one factor varies,
the others fi!ed, the proportion between the fi!ed factor and the variable factor will vary, (e.g., land
and capital will be fi!ed in the short run, while labour will be variable).*hat is why the law is called
the law of variable proportion. *he law of variable proportion is also known as the law of
proportionality, the law of diminishing returns, law of non8proportional outputs etc.
*he following table illustrates the operations of :aw of Aariable $roportion.
*able
3o. ;f workers *otal Average arginal 0emarks
(Aariable 'nput factor) $roduct $roduct $roduct
2 2Q 2Q 2Q
4 47 24 27
' .tage
5 5K 25 2<
7 <= 27 2>
< >Q 27 27
= >? 25 ?
'' .tage
> ?7 24 =
? ?7 2Q.< Q
K ?2 K 85 ''' .tage

*he law of variable proportion may be e!plained under the following three stages as shown in the
graph)
.tage 2) *otal product increases at an increasing rate and this continues till the end of this
stage. Average product also increases and reaches its highest point at the end of this stage.
arginal product increases at an increasing rate. *hus *$, A$ and $ 8 all are increasing.
%ence this stage is known as stage of increasing return.
.tage '') *otal product continues to increase at a diminishing rate until it reaches its
ma!imum point at the end of this stage. (oth A$ and $ diminish, but are positive. At the
end of the second stage, $ becomes "ero. $ is "ero when the *$ is at the ma!imum. A$
shows a steady decline throughout this stage. As both A$ and $ decline, this stage is
known as stage of diminishing return.
.tage ''') 'n this stage the *$ declines. A$ shows a steady decline, but never becomes "ero.
$ becomes negative. 't goes below the F a!is. %ence the 5rd stage is known as stage of
negative return.
Assumptions of t'e !a&
*he law of variable proportion is valid when the following conditions are fulfilled)
*he technology remains constant. 'f there is an improvement in the technology, due to
inventions, the average and marginal product will increase instead of decreasing.
;nly one input factor is variable and other factor are kept constant.
All the units of the variable factors are identical. *hey are of the same si"e and /uality.
A particular product can be produced under varying proportions of the input combinations.
*he law operates in the short run.
,'- %oes t'e !a& of Varia0le #roportions operate.
*he law of variable proportion operates on account of the following reasons)
'mperfect substitutes) *here is a limit to the e!tent to which one factor can be substituted for
another. 'n other words, two factors are not perfect substitutes. 6or e!ample, in the
construction of building, capital cannot substitute labour fully.
.carcity of the factors of production) ;utput can be increased only by increasing the
variable factors. 'n the short run certain input factors like land and capital are scarce. *his
leads to diminishing marginal productivity of the variable factors.
Economies and diseconomies of scale) *he internal and e!ternal economies of large scale
production are available as production is e!panded. *herefore average cost goes on
diminishing. (ut this continues only up to a certain stage. 9hen the production is e!panded
beyond a level the diseconomies will start entering into production. %ence the output will
come down (or cost will go up).
.pecialisation) *he stage of diminishing returns comes into operation when the limit to
ma!imum degree of specialisation reaches. *his stage emerges when the fi!ed factor
becomes more and more scarce in relation to the variable factor thereby giving less and less
support to the latter. As a result of this, the efficiency and productivity of the variable factor
diminish.
Importance of t'e !a& of Varia0le #roportion
*he law of variable proportion is one of the most fundamental laws of Economics. *he law of
variable proportion is applicable not only to agriculture but also to other constructive industries like
mining, fishing etc. 't is applied to secondary or tertiary sectors too. *his law helps the management
in the process of decision making.
*he law is a law of life and can be applicable anywhere and everywhere. *he applications of this law
are as follows)
;ptimum production) *his law can be used to estimate the optimum proportion of the
factors for the producer.
$rice determination) *his law is also important in the price determination.
E!planation of disguised unemployment) :ess developed countries like 'ndia have good deal
of disguised unemployment. any farm workers are in fact surplus. *his is called disguised
unemployment. *he law helps us in e!plaining the presence of disguised unemployment.
'n short, the law of variable proportion is a universal law.
!A,S O/ RETURNS TO SCA!E
*he term return to scale means the changes in output as all factors change in the same proportion.
*he law of returns to scale seeks to analyse the effects of scale on the level of output. 'f the firm
increases the units of both factors labour and capital, its scale of production increases.
*he return to scale may be increasing, constant or diminishing. 9e shall now e!amine these three
kinds of returns to scale.
'ncreasing 0eturns to .cale
9hen inputs are increased in a given proportion and output increases in a greater proportion, the
returns to scale are said to be increasing. 'n other words, proportionate increase in all factors of
production results in a more than proportionate increase in output 't is a case of increasing returns to
scale. 6or e!ample, if the inputs are increased by 7QT and output increased by <QT, return to scale
are increasing (N O2). 't is the first stage of production.
'f the industry is en#oying increasing returns, then its marginal product increases. As the output
e!pands, marginal costs come down. *he price of the product also comes down.
,onstant 0eturn to .cale
9hen inputs are increased in a given proportion and output increases in the same proportion,
constant return to scale is said to prevail. 6or e!ample, if inputs are increased by 7QT and output
also increases by 7QT, the return to scale are said to be constant (N 2). *his may be called
homogeneous production function of the first degree.
'n case of constant returns to scale the average output remains constant. ,onstant returns to scale
operate when the economies of the large scale production balance with the diseconomies.
+ecreasing 0eturns to .ale
+ecreasing returns to scale is otherwise known as the law of diminishing returns. *his is an
important law of production.
'f the firm continues to e!pand beyond the stage of constant returns, the stage of diminishing returns
to scale will start operate. A proportionate increase in all inputs results in less than proportionate
increase in output, the returns to scale is said to be decreasing. 6or e!ample, if inputs are increased
by 7QT, but output increases by only 5QT, (N P 2), it is a case of decreasing return to scale.
+ecreasing return to scale implies increasing costs to scale.
ISO 1uants

'so/uant is a combination of two terms, namely, iso and /uant. 'so means e/ual. Iuant means
/uantity. *hus iso/uant means e/ual /uantity or e/ual product. 'so/uants are the curves which
represent the different combination of inputs producing a particular /uantity of output. Any point on
the iso/uant represents or yields the same level of output. *hus iso/uant shows all possible ,omb
inations of the two inputs (say labour and capital) capable of producing e/ual or a -iven level of
output. 'so/uants are also known as iso product curves or e/ual product curves or production
indifferent curves.
An iso/uant may be e!plained with the following e!ample)
E/ual $roduct ,ombinations
*able
Combination )nits of labour )nits of Capital "otal #utput
A 4Q 2 2QQQ
( 2< 4 2QQQ
, 22 5 2QQQ
+ ? 7 2QQQ
E = < 2QQQ
3ow if plot these combination of labour and capital, we shall get a curve. *his curve is known as an
iso/uant.

Iso8uant Map or E8ual #ro%uct Map
An iso/uant map consists of a number of iso/uants. An iso/uant map gives a set
of e/ual product curves which show different production levels. Each iso/uant in the map
indicates different levels of output. A higher iso/uant represents a higher level of output.
*he distance of an iso/uant from the origin shows the relative levels of output. *he
farther the iso/uant from the origin the greater will be the level of output along it. (ut it
should be noted that the distance between two e/ual product curves does not measure the
absolute difference in the volume of output. 'so/uant map is shown in the following
diagram.

#roperties or /eatures of Iso8uant
*he following are the important properties of iso/uants)
'so/uant is downward sloping to the right) *his means that if more of one factor is used less
of the other is needed for producing the same output.
A higher iso/uant represents larger output.
3o iso/uants intersect or touch each other) 'f so it will mean that there will be a common
point on the two curves. *his further means that same amount of labour and capital can
produce the two levels of output which is meaningless. *he iso/uant as shown in 6ig. will
never e!ist.

'so/uants need not be parallel to each other) 't so happens because the rate of substitution in
different iso/uant schedules need not necessarily be e/ual. 1sually they are found different
and therefore, iso/uants may not be parallel.

'so/uant is conve! to the origin) *his implies that the slope of the iso/uant diminishes from
left to right along the curve. *his is because of the operation of the principle of diminishing
marginal rate of technical substitution.

3o iso/uant can touch either a!is) 'f an iso/uant touches F a!is then it would mean that
without using any labour the firm can produce output with the help of capital alone. (ut this
is wrong because the firm can produce nothing with ;L units of capital alone. ' an iso/uant
touches G a!is, it would mean that without using any capital the firm can produce output
with the help of labour alone. *his is impossible.
'so/uants have negative slope) *his is so because when the /uantity of one factor (labour) is
increased the /uantity of other factor (capital) must be reduced, so that total output remains
the same. 'f the marginal productivity of the factor becomes "ero the iso/uant will bend
back and it will have positive slope as shown below.
MAR3ET ANA!$SIS
#ER/ECT COM#ETITION
$erfect competition in economic theory has a meaning diametrically opposite to the everyday use of
the term. 'n practice, businessmen use the word competition as synonymous to rivalry. 'n theory,
perfect competition implies no rivarly among firms.
$erfect competition, therefore, can be defined as a market structure characterised by a complete
absence of rivalry among the individual firms.
6eatures)
:arge number of buyers and sellers) *here must be a large number of firms in the industry.
Each individual firm supplies only a small part of the total /uantity offered in the market.
*he price of the product is determined by the collective forces of industry demand and
industry supply. *he firm is only a Bprice taker. Each firm has to ad#ust its output or sale
according to the prevailing market price.
%omogeneity of products) 'n a perfectly competitive industry, the product of any one firm is
identical to the products of all other firms. *he technical characteristics of the product as
well as the services associated with its sale and delivery are identical.
6ree entry e!it) *here is no barrier to entry or e!it from the industry. Entry or e!it may take
time but firms have freedom of movement in and out of the industry. 'f the industry earns
abnormal profits, new firms will enter the industry and compete away the e!cess profits.
.imilarly, if the firms in the industry are incurring losses some of them will leave the
industry which will reduce the supply of the industry and will thus raise the price and wipe
away the losses.
Absence of government regulation) *here is no government intervention in the form of
tariffs, subsidies, relationship of production or demand.
'f these assumptions are fulfilled, it is called pure competition which re/uires the fulfillment
of some more condition.
$erfect mobility of factors of production) *he factors of production are free to move from
one firm to another throughout the economy. 't is also assumed that workers can move
between different #obs. 0aw materials and other factors are not monopolised and labour is
not unionised. 'n short, there is perfect competition in the factor market.
$erfect knowledge) 't is assumed that all sellers and buyers have complete knowledge of the
conditions of the market. *his knowledge refers not only to the prevailing conditions in the
current period but in all future periods as well.
'nformation is free and costless) 1nder these conditions uncertainty about future
developments in the market is ruled out.
Absence of transport costs) 'n a perfectly competitive market, it is assumed that there are no
transport costs.
#rice %etermination un%er perfect competition
$rice of a commodity in an industry is determined at that point where industry
demand is e/ual to industry supply. arshall laid emphasis on the role of time element in
the determination of price. %e distinguished three periods in which e/uilibrium between
demand and supply was brought about vi"., very short period or market period@ short run
e/uilibrium and long run e/uilibrium.
arket period
$rice is determined by the e/uilibrium between demand and supply in market period. 'n the market
period, the supply of commodity is fi!ed. *he firms can sell only what they have already produced.
*his market period may be an hour, a day or few days or even few weeks depending upon the nature
of the product. .o far as the supply curve in a market period is concerned, two cases are prominent8
one is that of perishable goods and the other is that of non perishable durable goods.
6or perishable goods like fish, vegetables etc. the supply is given and cannot be kept for the ne!t
period@ therefore, the whole of it must be sold away on the same day whatever be the price. *he
supply curve will be a vertical straight line.

.hort run e/uilibrium
'n the short period the firm can vary its supply by changing the variable factors.
oreover, the number of firms in the industry cannot increase or decrease in the short run.
*hus the supply of the industry can be changed only within the limits set by the plant
capacity of the e!isting firms. *he short period price is determined by the interaction of
short period supply and demand curves. *he determination of the short run price is shown
in figure.
:ong8run e/uilibrium
'n the long run, supply is ad#usted to meet the new demand conditions. 'f there is
an increase in demand, the firms in the long run will e!pand output by increasing the
fi!ed factors of production. *hey may enlarge their old plants or build new plants.
oreover, in the long run new firms can also enter the industry and thus add to the
supplies of the product. *he determination of price in the long run is shown in figure
MONO#O!$ COM#ETITION
onopoly is that market form in which a single producer controls the entire supply of a single
commodity which has no close substitutes. *here must be only one seller or producer. *he
commodity produced by the producer must have no close substitutes. onopoly can e!ist only when
there are strong barriers to entry. *he barriers which prevent the entry may be economic, institutional
or artificial in nature.
6eatures)
*here is a single producer or seller of the product.
*here are no close substitutes for the product. 'f there is a substitute, then the monopoly
power is lost.
3o freedom to enter as there e!ists strong barriers to entry.
*he monopolist may use his monopolistic power in any manner to get ma!imum revenue.
%e may also adopt price discrimination.
#rice6output %etermination un%er monopol-
*he aim of the monopolist is to ma!imise profits. *herefore, he will produce that level of output and
charge a price which gives him the ma!imum profits. %e will be in e/uilibrium at that price and
output at which his profits are ma!imum. 'n order words, he will be in e/uilibrium position at that
level of output at which marginal revenue e/uals marginal cost. *he monopolist, to be in e/uilibrium
should satisfy two conditions)
2. arginal cost should be e/ual to marginal revenue and
4. *he marginal cost curve should cut marginal revenue curve from below.
.hort run e/uilibrium

:ong run e/uilibrium
'n the long run the firm has the time to ad#ust his plant si"e or to use the e!isting plant so as to
ma!imise profits.
#rice %iscrimination monopol-
$rice discrimination refers to the practice of selling the same product at different prices to different
buyers. rs. 0obinson defines it as Ccharging different price for the same product or same price for
differentiated productC. $rof. .tigler defines price discrimination as Cthe scale of technically similar
products at prices which are not proportional to arginal costsC.
$rice discrimination may be divided into three types8personal, local and according to use. $rice
discrimination is personal when a seller charges different prices for different persons. 6or e!ample,
hair cut for children and adult. $rice discrimination is local when the seller charges different prices
for people of different localities. 6or instance, a seller may charge one price at domestic market and
another price in international market.
+iscrimination is according to use when the same commodity is put to different uses. 6or
e!ample, electricity is usually sold at a cheaper rate for industrial uses than for domestic
purposes.
Degrees of price %iscrimination
+ifference between three degrees of price discrimination.
$rice discrimination of the first degree
't is also known as perfect price discrimination. $rice discrimination of the first degree is
said to occur when the monopolist is able to sell each separate unit of the output at a
different price. 'n other words, it involves ma!imum possible e!ploitation of each buyer.

$rice discrimination of the second degree
'n price discrimination of the second degree buyers are divided into different groups and
from each group a different price is charged which is the lowest demand price of that group.
$rice discrimination of the third degree
't occurs when the seller divides his buyers into two or more than two sub8 markets or
groups and charges a different price in each sub8market. *he price charged in the sub8market
need not be the lowest demand price of that sub8market..
#ossi0ilit- of price %iscrimination
$rice discrimination is possible in the following cases)
*he nature of the commodity should be such as to enable the monopolist to charge different prices.
*his is possible only when there is no possibility of transference of the commodity from one market
to the other. 6or e!ample, doctors charge different fees for the rich and for the poor for same service.
2. 9hen the markets are separated by long distance or tariff, then price discrimination is
possible. 'f the transportation cost is higher than the price difference between the two
markets, one monopolist can charge different prices. 6or e!ample, a commodity may be sold
at 0s. 2Q in +elhi and 0s. 4Q in adras. 'f the transportation cost between +elhi and adras
is greater than 0s. 2Q it is not profitable for the consumers to transport the commodity from
+elhi to adras on their own. .imilarly when domestic market is protected by tariff, the
monopolist can sell the product at a lower price in the foreign market and at a higher price in
the domestic market.
4. 'n certain cases, the firms have a legal sanction for price discrimination. 6or e!ample,
electricity board charges a lower price for industrial purposes and a higher price for
domestic purposes. .imilarly, transportation companies charge different fares for different
classes of passengers.
5. $rice discrimination is possible due to preferences or pre#udices of the consumers. +ifferent
prices are charged for different varieties although they differ only in label or name. 1pper
class people may prefer to buy in fashionable /uarters to buy in a congested, ugly and
cheaper locality.
7. $rice discrimination may become possible due to ignorance and la"iness of buyers. 'f a
seller is discriminating between two markets but the buyers are ignorant that the seller is
selling the product at a lower price in another market, price discrimination is possible. $rice
discrimination is also possible if the buyers are aware that the seller is selling the product at
lower price in another market but due to la"iness may not go for shopping, in the cheaper
market.
<. 9hen a monopolist is able to meet different needs for his customers it is possible for him to
follow price discrimination. 6or e!ample, railways charge different rates for carrying coal,
cotton, silk and fruit even though the service rendered is the same for all.
=. A monopolist can easily charge discriminating prices when goods are being supplied to
special orders. 'n such a case, there is no /uestion of comparing prices by the buyers.
MONO#O!ISTIC COM#ETITION
onopolistic competition is more realistic than either pure competition or monopoly. 't is a blending
of competition and monopoly. C*here is competition which is keen though not perfect, between
many firms making very similar productsC. *hus monopolistic competition refers to competition
among a large number of sellers producing close but not perfect substitutes.
6eatures)
:arge number of sellers) 'n monopolistic competition the number of sellers is large. 3o one
controls a ma#or portion of the total output. %ence each firm has a very limited control over
the price of the product. Each firm decides its own price8output policy without considering
the reactions of rival firms. *hus there is no interdependence between firms and each seller
pursues an independent course of action.
$roduct differentiation) ;ne of the most important features of monopolistic competition is
product differentiation. $roduct differentiation implies that products are different in some
ways from each other. *hey are heterogeneous rather than homogeneous. *here is slight
difference between one product and others in the same category. $roducts are close
substitutes but not perfect substitutes. $roduct differentiation may be due to differences in
the /uality of the product. $roduct may be differentiated in order to suit the tastes and
preferences of the consumers. *he products are differentiated on the basis of materials used,
workmanship, durability, si"e, shape, design, colour, fragrance, packing etc. $roducts are
differentiated in order to promote sales by influencing the demand for the products. *his can
be achieved through propaganda and advertisement. Advertisement brings a psychological
reaction in the minds of the buyers and thus influences the demand.
'n addition, location of the shop, its general appearance, counter service, credit and other
facilities increase sales.
$atent rights and trade marks also promote product differentiation. Lodak and ,oca ,ola are
the e!amples of patent rights. *rade marks like %amam, 0e!ona, :u! etc. help the
consumers to differentiate one product over others.
6ree entry and e!it of firms) Another feature of monopolistic competition is the freedom of
entry and e!it of firms. 6irms under monopolistic competition are small in si"e and they are
capable of producing close substitutes. %ence they are free to enter or leave the industry in
the long run. $roduct differentiation increases entry of new firms in the group because each
firm produces a different product from the others.
.elling cost) 't is an important feature of monopolistic competition. As there is keen
competition among the firms, they advertise their products in order to attract the customers
and sell more. *hus selling cost has a bearing on price determination under monopolistic
competition.
-roup e/uilibrium) ,hamberlin introduced the concept of group in the place of industry.
'ndustry refers to a number of firms producing homogeneous products. (ut, firms under
monopolistic competition produce similar but not identical products. *herefore, chamberlin
uses, the concept of group to include firms producing goods which are close substitutes.
3ature of demand curve) 1nder monopolistic competition, a single firm can control only a
small portion of the total output. *hough there is product differentiation, as products are
close substitutes, a reduction in price leads to increase in sales and vice8versa. (ut it will
have little effect on the price8output conditions of other firms. %ence each will loose only
few customers, due to an increase in price. .imilarly a reduction in price will increase sales.
*herefore the demand curve of a firm under monopolistic competition slopes downwards to
the right. 't is highly elastic but not perfectly elastic. 'n other words, under monopolistic
competition, the demand curve faced by the firm is highly elastic. 't means that it has some
control over price due to product differentiation and there are price differentials between the
firms.
#rice6Output Determination un%er Monopolistic Competition
E/uilibrium of a firm under monopolistic competition is based upon the following
assumptions)
*he number of sellers is large and they act independently of each other.
*he product is differentiated.
*he firm has a demand curve which is elastic.
*he supply of factor services is perfectly elastic.
*he short run cost curves of each firm differ from each other.
3o new firms enter the industry.
O!IO#O!$
;ligopoly is a situation in which few large firms compete against each other and there is an element
of interdependence in the decision making of these firms. A policy change on the part of one firm
will have immediate effects on competitors, who react with their counter policies.
6eatures)
.mall number of large sellers) *he number of sellers dealing in a homogeneous or
differentiated product is small. *he policy of one seller will have a noticeable impact on
market, mainly on price and output.
'nterdependence) 1nlike perfect competition and monopoly, the oligopolist is not
independent to take decisions. *he oligopolist has to take into account the actions and
reactions of his rivals while deciding his price and output policies. As the products of the
oligopolist are close substitutes, the cross elasticity of demand is very high.
$rice rigidity) Any change in price by one oligopolist invites retaliation and counter8 action
from others, the oligopolist normally sticks to one price. 'f an oligopolist reduces his price,
his rivals will also do so and therefore, it is not advantageous for the oligopolist to reduce
the price.
;n the other hand, if an oligopolist tries to raise the price, others will not do so. As a result
they capture the customers of this firm. %ence the oligopolist would never try to either
reduce or raise the price. *his results in price rigidity.
onopoly element) As products are differentiated the firms en#oy some monopoly power.
6urther, when firms collude with each other, they can work together to raise the price and
earn some monopoly income.
Advertising) *he only way open to the oligopolists to raise his sales is either by advertising
or improving the /uality of the product. Advertisement e!penditure is used as an effective
tool to shift the demand in favour of the product. Iuality improvement will also shift the
demand favorably. 1sually, both advertisements as well as variations in designs and /uality
are used simultaneously to maintain and increase the market share of an oligopolist.
-roup behavior) *he firms under oligopoly recognise their interdependence and realise the
importance of mutual cooperation. *herefore, there is a tendency among them for collusion.
,ollusion as well as competition prevail in the oligopolistic market leading to uncertainty
and indeterminateness.
'ndeterminate demand curve) 't is not possible for an oligopolist to forecast the nature and
position of the demand curve with certainty. *he firm cannot estimate the sales when it
decides to reduce the price. %ence the demand curve under oligopoly is indeterminate.
T-pes of Oligopol-
;ligopoly may be classified in the following ways)
2. $erfect and imperfect oligopoly) ;n the basis of the nature of product, oligopoly may be
classified into perfect (pure) and imperfect (differentiated) oligopoly. 'f the products are
homogeneous, then oligopoly is called as perfect or pure oligopoly. 'f the products are
differentiated and are close substitutes, then it is called as imperfect or differentiated
oligopoly.
4. ;pen or closed oligopoly) ;n the basis of possibility of entry of new firms, oligopoly may
be classified into open or closed oligopoly. 9hen new firms are free to enter, it is open
oligopoly. 9hen few firms dominate the market and new firms do not have a free entry into
the industry, it is called closed oligopoly.
5. $artial and full oligopoly) $artial oligopoly refers to a situation where one firm acts as the
leader and others follow it. ;n the other hand, full oligopoly e!ists where no firm is
dominating as the price leader.
7. ,ollusive and non8 collusive oligopoly) 'nstead of competition with each other, if the firms
follow a common price policy, it is called collusive oligopoly. 'f the collusion is in the form
of an agreement, it is called open collusion. 'f it is an understanding between the firms, then
it is a secret collusion.
;n the other hand, if there is no agreement or understanding between oligopoly firms, it is
known as non8collusive oligopoly.
<. .yndicated and organised oligopoly) .yndicated oligopoly is one in which the firms sell
their products through a centralised syndicate. ;rganised oligopoly refers to the situation
where the firms organi"e themselves into a central association for fi!ing prices, output,
/uota etc.