Ncert XII Micro Economics

U N I T- I
N T R O D U C T I O N
INTRODUCTORY MICROECONOMICS
CHAPTER
INTRODUCTION
1.1 Central Problems of an

Economy
1.2 Production Possibility

Curve and Opportunity
Cost
1.3 Micro versus Macro

Economics
TO
ECONOMICS
Welcome to the science of economics. Yes,

economics is a social science, like chemistry
is a physical science. It is true that there are
no test tubes and sophisticated equipment
required to study economics, but just as
physical sciences are means to understand
how the real physical world around us
works our planet, the solar system or the
universe in economics, we try to understand
how the economy of a particular region, a
country, or the global economy works. There
are principles or laws of economics (parallel to
laws of chemistry or physics). With the help
of these principles, we analyse how an
economy works.
What is economics after all? There is no
universally accepted, single, definition of it.
But we can understand what it is about. Many
non-economists think that it only concerns
the matters of money how to make or manage
money. Not true. Economics is about making
choices in the presence of scarcity. The notions,
scarcity and choice, are very important in
economics. You may not see these words in all
chapters to come, but they are in the
background throughout. Scarcity and choice
go together: if things were available in plenty
(literally) then there would have been no choice
problem; you can have anything you want.
INTRODUCTION
TO
ECONOMICS
Unfortunately, this may be true only in

heaven, not in the real world. Even the
richest person on earth would have to
face scarcity and make choice. If
nothing else, time is scarce. Ratan Tata,
a leading industrialist of India, between
6 p.m. and 8 p.m. in a particular
evening, may have to decide whether to
go to a musical concert, or just keep
working in his office. Think about the
length of syllabi of various subjects that
you have to cover before the final exam.
We do not need to convince you that
time is scarce. Likewise, food, clothing,
housing, clean air, drinkable water etc.
are scarce in every country in the
world, except that the degree of
scarcity varies. The point is that
problems of choice arise because of
scarcity. The study of such choice
problems, at the individual, social,
national and international level is what
economics is about.
1.1 CENTRAL PROBLEMS OF AN
ECONOMY: WHAT, HOW AND
FOR WHOM
There are many choice problems that
any particular economy attempts to
solve within a given time period. For
example, during the fiscal year 1998-99,
71.3 million tons of wheat was
produced in India.1 Output of food
grains in general is not entirely
determined by external factors like
1
2
3
rainfall etc. It is partly influenced by

how much of land is used to raise food
grains, by the application of fertilisers,
by the supply of power to agricultural
sector etc. And these are consequences
of individual choice as well as policies
by the government. Thus Indias wheat
production in a given year is, partly,
an outcome of choice.
India, as many other countries,
does not produce jet planes. But it
produces helicopters, small air-crafts
for training purposes as well as some
fighter planes. 2 This also reflects a
choice problem.3
Not only what goods a nation
should produce is a problem of
choice, so is how or in which method
a good is to be produced. Usually,
there is more than one method to
produce a given commodity. For
example, agricultural activity is more
labour -intensive in India than in
developed countries like US, France
or Germany.
Who is paid how much is also a
choice problem from the economys
viewpoint. There are differences in pay
or salary across occupations. For
instance, in the latter half of 1990s the
beginning salary (including allowances)
for a Class I government servant was
between Rs. 1.5 lakhs to Rs. 2 lakhs
per annum. In comparison, on the
average, a computer programmer in
The source is Ministry of Finance, Government of India, Economic Survey 2000-2001, published in 2001.
These are produced by Hindustan Aeronautics Limited (HAL). We recommend you to visit its website:
www.hal-india.com. It contains pictures and brief descriptions of different aircrafts produced by HAL.
You may argue that India does not produce jet planes because it does not have the necessary technology.
However, having a technology or not can be seen as a choice problem. Many technologies can be purchased
if we decide to pay for it. But we do not and should not buy any available technology even if we
can afford it. We have to weigh the benefits from having a technology against the cost of acquiring it.
India was receiving Rs. 2.58 lakhs per

annum in 1999.4
Various economic problems facing
an economy can be categorised into
three types. These are the so-called
what, how and for whom
problems. They arise due to scarcity.
What to be: What goods and services
are produced and in what quantities?
For example, in the fiscal year 199798, the Indian economy produced 82.1
million tons of cement. Why is it 82.1
million tons, not 40 million tons? In the
same year India produced 9.8 million
bicycles.5 What factors determine these
quantities? And so on.6
How to be: How (i.e. by which methods)
would the goods and services be
produced? Should garments in India
be produced by relatively labour intensive or machine-intensive
methods? What techniques of
production are to be used?
For whom to be: Given that various
goods and services are available to an
economy, who gets how much to
consume? This essentially refers to who
earns how much or who has more
assets than others. For example, how
much a computer engineer consumes
is based on his earnings compared to a
chemical engineer or a high-school
teacher? This is the for whom
question. It refers to distribution of
income and wealth in the society.
4
5
6
In a market-oriented or capitalist
economy, these fundamental problems
are solved by the market. There is
a price, which is influenced by the
forces of demand and supply. These
forces guide which goods and how
much is to be produced and
consumed. For example, alu bhujia
is produced in the Indian economy
because the technology of making alu
bhujia is available, the cost of
producing and supplying it is not too
high and there is demand for alu
bhujia. This illustrates how the what
problem is solved in a market-oriented
economy.
Suppose that the oil production in
the world market declines drastically for
some reason. This will increase the price
of diesel and petrol world-wide. A taxi
company in Ludhiana, which was
running 10 taxis, will now wish to
convert some of them to CNG
(compressed natural gas). In other words,
the method of production of taxi service
will change. This example illustrates how
the how problem is solved.
As another example, if there is an
increase in demand for computer
hardware and software by businesses
and households, this will push up the
demand for services by computer
engineers. As a result, their salaries
(prices) would increase. These
See Ed.Frauenheim, India Inc., TechWeek, September 20, 1999 (also see http://www.techweek.com).
This salary figure, stated in US dollars, is $6,000. At the 1999 dollar-rupee exchange rate of
$1 = Rs. 43, it becomes Rs. 2.58 lakhs.
The source is Economic Survey 2000-2001, Ministry of Finance, Govt. of India, 2001.
These are examples of goods or commodities that have physical dimensions. Services refer to
tasks being performed for someone, e.g., a hair-cut, education, doctors advice etc. What problem
applies to services as well.
INTRODUCTION
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ECONOMICS
engineers would now have more

purchasing power (money and wealth)
and can buy more goods and services
than before. This is an example of how
the solution of for whom problem
changes over time.
The following chapters examine in
detail how these central problems are
addressed in a market-oriented
economy.
Alternatively, in a centrally planned

economic system, which was in
practice in the former Soviet Union and
other East European countries till the
late 1980s, these problems are
addressed in a very direct way by the
government. See Clip 1-1 for details.7
Clip 1-2 provides an account of the
demerits of a central planning system
relative to a capitalist system.
CLIP 1-1
A Centrally Planned Economy*
In a centrally planned economy, there is a central planning authority, a wing of
the government. It decides which goods and how much should be consumed and
produced in the economy within a given span of time, say within a year or in five
years. These are like targets. They are set according to the overall growth and
development strategy for the economy that is considered desirable by the members
of the planning authority. Once the total production target levels are fixed, they
are then allocated over different factories, which are supposed to deliver the amounts
required. Realise that production of any particular good (e.g. bicycles) requires
other goods as well (e.g. steel, rubber pedals etc.) In turn, these other goods
require different other goods as well. Hence it is a massive planning process that
takes into account simultaneous production of thousands of goods. This is how
the what problem is attended.
With respect to the how question, factories are government-owned and the method
of production is chosen by the planning authority. Thus the how problem is
solved by the government.
Properties are government-owned too. It also determines salaries of various skills.
Hence the for whom problem is solved by the government also. In other words,
all three central problems are essentially addressed by the government in a direct
way by command so-to-speak. That is why a centrally planned economy is also
called a command economy.
7
However, no economy in the world is cent per cent centrally planned or market-oriented. If both the
private sector (i.e. market forces) and the government play almost equal roles in the functioning of the
economy, then such an economy is called a mixed economy. Otherwise, if government or public sector
activities are dominant, we call it a centrally planned economy (e.g. the former Soviet Union). If private
sector activities are dominant, we call it a market-oriented or a capitalist economy (e.g. United States
and Japan).
The Indian economy, until the end of the seventies, was a very much a mixed economy. It is still considered
a mixed economy today, but since the 1980s has been gradually moving towards a market-oriented
economy. It is much less controlled and private firms operate in a much more liberalised environment
now, than in 1960s or 1970s.
* All Clips are NETs (not for exams and tests).
1.2 PRODUCTION POSSIBILITY

CURVE AND OPPORTUNITY
COST
From a general discussion about
economics and how an economy works,
we now move to a specific issue and
look at it analytically. It sets the tone
for the type of economic analysis to
come in the following chapters.
To begin with, suppose that
Mr. Kheti Lal, a farmer in U.P., owns 50
acres of land for cultivation. He can grow
wheat or sugar cane or both. Suppose
that the production technologies of
wheat and sugar cane are such that one
acre of land yields 2500 kgs of wheat or
80 tons of sugar cane. How does
Mr. Kheti Lal decide how much of land
he should use for wheat and how much
for sugar cane?
A natural way is to first determine
the various combinations of wheat and
sugar cane that he can grow, given the
total land he has and given the
technologies of producing wheat and
sugar cane. Next, he can select a
particular combination, depending on
profitability of raising wheat and sugar
cane. We are not interested in the latter
issue, but only in how much of wheat
and sugar cane are feasible for
Mr. Kheti Lal to produce.
For example, he uses all his land
in growing wheat. Then he can
produce 125 tons of wheat and zero
sugar cane. Instead, if he uses all his
land to grow sugar cane, then he get
zero wheat and 4,000 tons of sugar
cane. There are, obviously, many other
possibilities. For instance, he can use
30 acres of land on wheat and 20 acres
on sugar cane, and, this will give him

75 tons of wheat and 1, 600 tons of
sugar cane. The important point to note
here is that, as long as Mr. Kheti Lal uses
all his land resource, which is given,
having more of one good implies having
less of the other. Interestingly, an
economy as whole, whether it is
market-oriented or not, faces a similar
situation.
At any given point of time, the
technologies available to produce
various goods and services as well as
the resources available to an economy
(meaning the size of its working
population, land, buildings, machinery
etc.) are all given. Evidently, an
economy cannot produce an unlimited
amount of any particular good or
service. If all resources are used in
producing a single good say,
computers, only a given number of
computers can be produced. Starting
from a given allocation of resources to
different sectors of an economy, if more
resources go into one particular sector
(e.g. the computers), less is available
for other sectors. In order to decide
which combination of goods serves the
economy the best, we have to first
identify various combinations that can
be available to an economy (like
different combinations of wheat and
sugar cane Mr. Kheti Lal can grow).
This is best illustrated through a
concept called the production
possibility curve, which will be defined
in a moment.
Now consider a hypothetical
economy, in which two goods can be
produced: cricket bats and saris.
INTRODUCTION
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ECONOMICS
(Assume that all cricket bats are of the

same quality and so are saris.) Suppose
that if all resources of this economy
(such as land and total amounts of
skilled and unskilled labour available
to the economy) are used in the sari
sector and if they work efficiently,
75 lakh saris can be produced (within,
say, a year). Assume that the same
resources can produce cricket bats
also. If, instead, all resources are
employed in producing cricket bats,
suppose that 5 thousand bats can be
made. These are two production
possibilities and both are rather
extreme. Most likely there will be other
possibilities which are intermediate.
For instance, if the economy is
producing 50 lakh saris, it can
produce, say, 3 thousand cricket bats.
Table 1.1 summarises the various
production possibilities that are
available to the economy. Not
surprisingly, you see that as the
production of one good increases that
of the other falls. This is because
resources are scarce. As more resources

go into one sector and produce more,
less is available for other sectors and
they will produce less than before.
Let us now plot these possibilities,
namely, (0, 75), (1, 70) etc. and join
the line segments.8 This gives rise to a
curve as shown in fig. 1.1(a). (Ignore
panel (b) for the moment.) It measures
one good along the x-axis and the other
on the y-axis. This is the production
possibility curve of our hypothetical
economy. If we consider an economy
in which, more realistically, there are
numerous production possibilities, not
just 6 as in Table 1.1, then we get a
smooth curve as shown in fig. 1.1(b).
This is how a production possibility
curve (PPC) is normally exhibited.
Formally, it is defined for a two-good
economy, and, it shows various
combinations of the two goods that
can be produced with available
technologies
and
with
given
resources, which are fully and
efficiently employed. Equivalently, the
Table 1.1 Production Possibilities

Production of Cricket Bats
Production of Saris
(in thousands)
(in lakhs)
Possibility A
75
Possibility B
70
Possibility C
62
Possibility D
50
Possibility E
30
Possibility F
An introduction to graph plotting and joining points is given in Appendix 1.
PPC shows the maximum amount that

can be produced of one good, given the
amount produced of the other good. A
(a)
India) or resources work inefficiently (e.g.

machines or plants are kept idle), then
the economy will operate strictly within
the PPC, e.g. at point G, (see fig. 1.1(b)). It
should be clear however that, by
definition, an economy cannot operate at
any point outside of the PPC, such as at
point H. Moreover, assuming that the
economy is operating on the curve, we
cannot, without further information, say
the exact point of operation. It depends
on preferences and tastes of individuals
in the economy.
You should realise that, although
PPC is defined in the context of a
two-good economy, the idea behind it
is general and holds for any number of
goods. It illustrates the maximum
production capabilities of an economy
at a given point of time.
1.2.1 Marginal Opportunity Cost,
Increasing Marginal Opportunity Cost and the Shape of
the PPC
(b)
Fig. 1.1
Production Possibility Curve
PPC is downward sloping, because

more production of one good is
associated with less of the other.9
Note that the PPC does not show or
say which point the economy will actually
operate on. It only shows the possibilities.
The economy may not be even operating
on the curve. For example, if there is
unemployment (as true for a country like
9
We already know that, along a PPC,

more production of one good means
some sacrifice of the other good. The
rate of this sacrifice is called the
marginal opportunity cost of the
expanding good. Go back to Table 1.1.
Starting from possibility B, if the
production of cricket bats increases by
one unit (to 2), 70 62 = 8 lakh saris
need to be forgone. Hence, at the
production possibility C, the marginal
opportunity cost of cricket bats is
equal to 8 lakh saris. Similarly, when
3 thousands bats are produced, the
The concept of downward sloping is explained in Appendix 1.
INTRODUCTION
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ECONOMICS
marginal opportunity cost (per

thousand bats) is 12 lakh saris, and,
so on. Generally, the marginal
opportunity cost of a particular good
along the PPC is defined as the amount
sacrificed of the other good per unit
increase in the production of the good
in question.
Note that marginal means
additional, and, it is a very important
notion in economics. You will see
repeated use of it in later chapters.
Table 1.2 is an expanded version
of Table 1.1 and lists the marginal
opportunity cost of cricket bats. We
observe that, as the production of
cricket bats increases, its marginal
opportunity cost increases (from 5 to
8, 8 to 12 and so on). These numbers
are indicated in column (3). Why does
the marginal opportunity cost
increase? The economic reason is that,
as more and more of a good is
produced, factors producing it become
marginally less and less productive.
Hence more and more of the other good
has to be sacrificed to ensure a unit
(given) increase of the former good.
Table 1.2
Increasing marginal opportunity cost

implies that the PPC is concave to the
origin. If, instead, the marginal
opportunity cost were decreasing, you
can check, by constructing an example,
that the PPC will look convex. Finally, if
the marginal opportunity cost were
constant, the PPC will be a straight line;
an important example of this will be
studied in Chapter 8. Typically however,
the marginal opportunity cost of a
particular good on the PPC is increasing
and therefore the PPC is concave [as
shown in fig. 1.1(b)].
1.2.2 Opportunity Cost A More
General Concept
The concept of opportunity cost is very
important and universal - not specific
to PPC. Most generally, the opportunity
cost of a given activity is defined as
the value of the next best activity. As
an illustration, suppose that you are a
doctor having a private clinic in New
Delhi and your annual earnings are Rs.
8 lakhs. There are two other alternatives
to having a clinic in New Delhi. Either
you can work in a government hospital
Marginal Opportunity Cost along the PPC
Production of
Cricket
Bats (in thousands)
Production of
Saris
(in lakhs)
Marginal
Opportunity
Cost of Bats (in saris)
0
1
2
3
4
5
75
70
62
50
30
0
5
8
12
20
30
10
in New Delhi, earning Rs. 4 lakhs

annually, or you can open a clinic in
your home town, Mumbai, which would
have generated an annual income of Rs.
3 lakhs. Then your opportunity cost of
having a clinic in New Delhi is Rs. 4
lakhs because you forego an income of
Rs. 4 lakhs from the second best
alternative of working in a government
hospital.
In the context of PPC, there are only
two goods, and therefore, the
opportunity cost of (additionally)
producing one has to be defined in
terms of the only remaining good.
Fig. 1.2
Shift of the PPC
1.2.3 Shift of the PPC

We now return to our discussion of the
PPC. Note that, although a given PPC
shows that, if the production of one
good goes up, the (maximum)
production of the other must fall, you
should not however think that an
economy can never produce more of all
goods. Over time, if the technologies
progress or if the resources available to
an economy (such as different types of
equipment, the sizes of unskilled
and skilled labour force etc.) grow,
then the economy can produce more of

both goods. That is, the PPC can shift
to the right, such as from AC to FH in
fig. 1.2.
It may be noted at this point that
the following chapters contain many
analytical constructs or curves (like
PPC), which will be derived from
economic considerations. It will be
good idea for you to go through
Appendix 1 thoroughly now, if you
have not done so already.
1.3 MICRO
VERSUS
ECONOMICS
MACRO
So far we have discussed in general

what economics is about, and analytical
concepts like PPC and opportunity
cost. The discipline of economics
is vast, and, it has many branches
or sub-disciplines. Out of them,
there are two core branches,
called
microeconomics
and
macroeconomics. The former refers
mostly, but not exclusively, to the
analysis of scarcity and choice problems
facing a single economic unit such as a
producer or a consumer. Consider an
example of producing a service say,
hair-cut. If you own a barber shop, how
many barbers should you hire? How
many persons should you serve per day
on the average? What price are you
going to charge for a crew-style haircut?
As another example, given your
monthly pocket money, how many ice
creams and chocolates you are going
to buy? These are questions of
individual choice. Microeconomics deals
with the principles behind such choices.
INTRODUCTION
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ECONOMICS
11
On the other hand, macro economics

deals with the behaviour of aggregates
such as real Gross Domestic Product
(GDP), employment, inflation etc. What
determines the real GDP or inflation rate
in an economy? What policies can

reduce the rate of unemployment in a
developing country like India? And so on.
This book is designed to cover some
basic principles of microeconomics.
CLIP 1-2
Capitalism Versus Central Planning*
We all know that the Soviet Union along with its economic system - broke down in
the late 1980s. Even the Chinese economy that used to be centrally planned is
moving vigorously towards a market system today. Why did the central planning
system fail?
While the ultimate goals of a central planning system are same as that of a
market-oriented economy, i.e., improvement of standard of living of people, the
means of achieving them in the former suffers from two inherent flaws, namely,
(a) lack of coordination and (b) lack of individual incentives. A modern economy
produces millions of different kinds of goods and services. Obviously, a central
coordination of activities in all or most of these sectors is bound to fail because
of unanticipated events or just human error. And a failure to achieve the targeted
level of production in one sector will create problems for many other sectors.
Equally or probably more serious is the problem of individual incentives. Since
which goods and how much to be produced are already decided by a central body
and there is no immediate or adequate reward for innovation, there is little incentive
to discover new or better quality products. Also, guranteed life-time employment
in the government-run industries or businesses provided no incentive to work
sincerely or efficiently. Work according to ones ability remained only an ideal, as
there was little reward for it.
On the other hand, the market economy provides an opportunity and incentive
for individuals to take risks, which is essential for inventions and to voluntarily
work according to ones ability. Individual freedom is respected and rewarded definitely more so than in a centrally planned system.
The capitalist system has its serious problems too. Fluctuations, i.e., periodic
recessions or depressions, are problems of one kind. Profit-oriented businesses
may disregard the adverse impact of industrial activity on local or global
environment. Such problems call for government restrictions, but only in selective
and discrete ways. They do not imply that direct government control over most
economic activities in the economy as in centrally planned economies is the
right solution.
* We need not mention NET in every clip.
12
SUMMARY
l
Economics is a social science.
Economics is concerned with the study of individual and social choice

in situations of scarcity.
There are three central problems facing any economy, namely, what,
how and for whom.
The what problem refers to which goods and services will be produced
in an economy and in what quantities.
l
l
The how problem refers to the choice of methods of production of goods

and services.
The for whom problem concerns with the distribution of income and
wealth.
In a capitalist or market-oriented economy, these problems are addressed

through the operation of markets.
Normally, the production possibility curve is concave to the origin. It is

because of increasing marginal opportunity cost.
A production possibility curve shifts out due to technological progress

or increases in the supply of resources available to an economy or both.
EXERCISES
Section I
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
What is economics about?

Name any two central problems facing an economy.
Define the production possibility curve.
Define marginal opportunity cost along a PPC.
What does increasing marginal opportunity cost along a PPC
mean?
Define opportunity cost.
What is microeconomics?
What is macroeconomics?
INTRODUCTION
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ECONOMICS
13
Section II
1.9
1.10
1.11
1.12
1.13
1.14
1.15
1.16
1.17
1.18
1.19
Explain how scarcity and choice go together.

Economics is about making choices in the presence of scarcity.
Explain.
What are the central problems of an economy and why do they
arise?
Explain any two central problems facing an economy.
Explain the central problem of what with examples.
Explain the central problem of how with examples.
Explain the central problem of for whom with examples.
Why does the PPC look concave to the origin?
An economy produces two goods: T-shirts and cell phones. The
following table summarises its production possibilities.
Calculate the marginal opportunity costs of T-shirts at various
combinations.
T-shirts
(in millions)
Cell phones
(in thousands)
90,000
80,000
68,000
52,000
34,000
10,000
Draw the production possibility curve for the example of

Mr. Kheti Lal in the text.
Suppose you have to practice question-answers for two subjects:
mathematics and social science. You have 8 hours to study.
You are very good at answering multiple choice questions in
mathematics: 20 questions per hour, while you are not that
good in answering such questions in social science: 12
questions per hour. Derive your production possibility schedule
and plot it. (The two goods here are (i) mathematics questions
practised and (ii) social science questions practised.)
14
1.20
1.21
1.22
1.23
1.24
1.25
1.26
1.27
1.28
1.29
Give two examples of under-utilisation of resources.

An economy always produces on, but not inside, a PPC.
Defend or refute.
Define opportunity cost and explain it with the help of an
example.
Suppose that you choose the science stream. You had two
other options: the arts stream (A) or the commerce stream
(C). If you would have chosen (A), you would have expected a
career, offering you Rs. 3 lakhs annually. If you would have
chosen (B), you would have expected a career, giving you Rs.
4 lakhs annually. What is your opportunity cost of choosing
the science stream? (Note: It is only a hypothetical example.)
Massive unemployment shifts the PPC to the left. Defend or
refute.
Which factors lead to a shift of the PPC?
Give two examples of growth of resources.
Why do technological advance or growth of resources shift
the PPC to the right?
A lot of people die and many factories are destroyed because
of a severe earthquake in a country. How will it affect the
countrys PPC?
Distinguish between microeconomics and macroeconomics.
Section III
1.30
A country produces two goods: green chilli and sugar. Its

production possibilities are shown in the following table. Plot
the PPC in a graph paper and verify that it is concave to the
origin. What is the pattern in the table that gives rise to the
concave shape of the PPC?
Green Chilli
Sugar
Possibility A
100
Possibility B
95
Possibility C
85
Possibility D
70
Possibility E
50
Possibility F
25
U N I T- I I
CONSUMER BEHAVIOUR
DEMAND
AND
16
CHAPTER
CONSUMER CHOICE
AND THE DEMAND CURVE
2.1 Consumer's Equilibrium

2.2 Meaning and
Determinants of Demand
2.3 Market Demand Curve

2.4 Price Elasticity of
Demand
In Chapter 1 it was stated that, in a marketoriented economy, the central problems of

what, how and for whom are solved
through forces of demand and supply for
various goods and services. Who demands a
particular good and who supplies it? This
depends on the type of good or service in
question.
Consider a final product such as alu
bhujia.1 As consumers, households are the
demanders of alu bhujia and companies like
Bikanerwala and Leher are the suppliers.
Another example is the service of a computer
programmer. This service is demanded by
companies or firms. Who are the suppliers of
this service? The households, because some
members of some households work as
computer programmers.
In summary, in case of final goods and
services, households demand them and firms
supply them. In case of services that are
required for production, households are the
1
Final goods and services include things that are consumed

by households, e.g. a piece of bread, a haircut, a bicycle
repair job etc. As opposed to final goods and services,
there are intermediate goods (or raw materials) that
are consumed (i.e. used up) by businesses. The
examples are steel in a bicycle factory, wheat in a flour
mill, and various automobile components in a Maruti car
workshop.
CONSUMER CHOICE
AND THE
DEMAND CURVE
suppliers and the fir ms are the

demanders.
This chapter deals with households
as consumers and their demand for
final goods and services. How should a
consumer decide how much of a
product to buy? What factors do affect
this decision and how?
2.1 CONSUMERS EQUILIBRIUM:
THE BASIS OF THE LAW OF
DEMAND
Let us ignore for the moment the word
equilibrium or the phrase Law of
Demand, and focus on the question of
how much of any particular good a
consumer should demand (or buy) at
a given point of time. In order to
understand this, we first have to learn
a few concepts.
2.1.1 Utility Concepts
We begin with the notion that a
consumer derives some satisfaction
from consuming a product; otherwise,
she would not demand it at all. This is
captured by a term called total utility,
defined as the total psychological
satisfaction a consumer obtains from
consuming a given amount of a
particular good. Consider for example
your consumption of gol guppa - the
mouth-watering small round-shaped
puffed puris, served with tamarind
(imli) water and fillings.1
Imagine that you are hungry and
have come to your favourite gol guppa
vendor. Suppose that if you consume
only one gol guppa you derive 20
units of pleasure or utility measured
in some units. Let this (psychological)
1
17
unit be called utils. Thus, the total

utility from consuming one gol guppa
is 20 utils. Suppose that you like gol
guppa so much that eating just one
increases your appetite for it. Let the
second unit give an additional utility
of 22 utils. Then, the total utility from
consuming two gol guppas is 20+ 22 =
42 utils. In the same manner we can
calculate total utility from consuming
three, four or five units and so on.
Besides total utility, there is
another important concept called
marginal utility, defined as the utility
from the last unit consumed. Thus
the marginal utility from consuming
one gol guppa is 20 and that from
consuming two gol guppas is 22. You
can now notice the relationship that
total utility is the sum of marginal
utilities.
Getting on with our story, your
intensity of desire for gol guppa must
fall, after consuming a certain amount,
regardless of how much you like gol
guppa. Suppose that, in your case,
such decline in the intensity of desire
starts with the third gol guppa you
consume. Accordingly, let the third
unit give you utility equal to a number
less than 22, say, 18 utils. That is, the
marginal utility and the total utility
obtained from consuming three gol
guppas are 18 and 42 +18 = 60 utils
respectively. The next (fourth) unit
gives you still less utility, say,
14 utils, and so on.
This pattern of marginal utility is
called the law of diminishing
marginal utility. It states that, after
consuming a certain amount of a good
Incase gol guppa is not known to the children, the teachers can use other popular eatable as
example to explain the concept.
18
with the 10th unit be -7 utils. That is,

the marginal utility of ten gol guppas is
-7 utils. (If you are crazy and still eat
more, each additional one can only give
you more negative utility.)
Table 2.1 summarises your
experience with gol guppa in terms of
marginal utility and total utility up to
10 units of consumption. Columns (2)
and (3) present the marginal and total
utility schedules.
or service, the marginal utility from it

diminishes as more and more is
consumed. If you think about it, this
law is very natural and should hold
for any product one consumes. In fact
it is considered as a fundamental
psychological law. You will see the
critical role of it a little later.
Let us resume our story once again.
When you have already consumed quite
a few gol guppas say 8, and you are
very full in your stomach suppose
that the next (9th) unit gives zero utility.
Imagine what will happen if you keep
gulping more. Suppose that eating the
10th unit makes you vomit! This is
obviously not a pleasant experience and
should give you negative satisfaction.
Accordingly, let the utility associated
Table 2.1
2.1.2
How many Gol Guppas will

you consume or buy?
From Table 2.1, it is clear that if you

are a rational (not crazy) consumer,
you will eat less than 10 gol guppas,
since consuming 10 or more gives you
negative marginal utility. If gol guppas
Marginal and Total Utility
Units Consumed of
Gol guppa
Marginal Utility
(in utils)
Total Utility
(in utils)
20
20
22
42
18
60
14
74
11
85
93
97
99
99
10
-7
92
CONSUMER CHOICE
AND THE
DEMAND CURVE
were free, i.e., its price were zero, you

would have consumed 8 or 9 units at
which your total utility is at its
maximum. But as long as you pay
something for it, you may not wish to
consume so many. You would like to
know how much utility you could have
obtained if you had spent some
amount on other items, e.g., ice cream,
chocolate etc. In other words, exactly
how many gol guppas you will eat
would depend not only on marginal
and total utility from consuming gol
guppas, but also on the price of gol
guppas, and, how much a rupee is
worth to you in terms of other goods.
We now define marginal utility of
one rupee as the extra utility when an
additional rupee is spent on other
available goods in general. Suppose
that, for you, it is 4 utils and let the
price of gol guppa be Rs. 2 per piece.
Having the information on price
and marginal utility of a rupee, we can
determine how many gol guppas you
will consume. Consider first whether
you will buy just one gol guppa. From
consuming only one, you obtain utility
equal to 20 utils (from Table 2.1). Since
the marginal utility of a rupee is 4 utils,
we can say that, from consuming
one gol guppa, you get utility worth
Rs. 20/4 = Rs. 5. On the other hand,
you pay and thus sacrifice Rs. 2 for
it. Hence you will buy the first unit.
Similarly, from the second unit, you
get utility worth Rs. 22/4 = Rs. 5.50,
while you pay only Rs. 2. Hence you
will buy the second gol guppa also.
We keep on making such
comparisons for successive units. For
19
example, the 5th gol guppa is worth

having it since it gives Rs. 11/4 =
Rs. 2.75 worth of utility, which is
greater than the price.
What happens with the 6 th gol
guppa is a bit different. It gives you
utility worth Rs. 8/4 = Rs. 2, which is
equal to the price. Will you buy it? The
answer is that you will be indifferent,
that is, whether or not you buy the 6th
unit does not make any difference.
However, it is clear that you will not buy
(consume) more than 6. Because, at any
level of consumption beyond 6, the
marginal utility in terms of rupees is
less than the price (you can check this
directly). Hence we have found the
answer to our query: you will buy 5 or
6 gol guppas.
The above comparisons between
how much of marginal utility in terms
of money you get and the price you pay
implies that, at either of these two levels
of consumption, the difference between
the total utility in terms of money and
your total expenditure on gol guppas
(defined as price quantity purchased)
is maximised. Table 2.2 illustrates this.
Its second column gives total utility in
terms of money, defined as total utility
divided by the marginal utility of one
rupee (equal to 4 utils in this example).
Column (3) gives your total expenditure
or spending on gol guppas. The last
column gives the difference between
these two columns; this is like the net
gain to a consumer. We see that this
difference is maximised (equal to
Rs. 11.25) when your gol guppa
consumption is either 5 or 6.
Having gone through the example,
we can now understand why this
20
Table 2.2
Difference between Total Utility in Terms of Money and Total

Expenditure
Amount Consumed
of gol guppas
Total Utility in
terms of money (Rs.)
Total
Expenditure (Rs.)
Difference
(Rs.)
10.50
6.50
15
18.50
10.50
21.25
10
11.25
23.25
12
11.25
24.25
14
10.25
24.75
16
8.75
24.75
18
6.75
10
23
20
section is titled Consumers

Equilibrium. The word equilibrium,
frequently used in economics, means a
position of rest. In this example, you
will rest, stop or, as economists say,
attain consumers equilibrium at 5
or 6 gol guppas. Because you do not
want to consume less or more than
these quantities. In general, we can
then say that consumers equilibrium
with respect to the purchase of one
good is attained when the difference
between total utility in terms of money
and the total expenditure on it is
maximised.
consumers equilibrium with respect to

any particular good. Recall that one of
our answers is 6 gol guppas. Ignoring
the other answer for the moment, note
that, at this level of consumption, the
marginal utility in terms of money (Rs.
2) is equal to price (Rs. 2). This is indeed
the principle and we can state this in
two alternative ways. That is, the
consumer s equilibrium is attained
when
2.1.3 The General Principle
(B )
From the example just worked out, we

can now derive the general principle of
(A)
Marginal Utility of a Product

Marginal Utility of a Rupee
= Its Price
Or
Marginal Utility of a Product

Its Price
= Marginal Utility of a Rupee.
CONSUMER CHOICE
AND THE
DEMAND CURVE
In particular, the condition (A) says

that the marginal utility of a product in
terms of money be equal to its price.
Sometimes, this is loosely stated as
marginal utility is equal to price.
Now go back to the example once
again and see that the consumers
equilibrium is also attained at 5 gol
guppas, where the principle is not
satisfied. This possibility exists because
gol guppas are not perfectly divisible:
they cannot be measured continuously
like points on a straight line. If, instead,
a product is perfectly divisible and thus
can be measured continuously, for
example by weight on a weighing scale,
there will be just one level of
consumption at which the consumers
equilibrium is achieved, with condition
(A) [or (B)] met.
We do implicitly assume from now
on that a product is perfectly divisible
and thus treat (A) or (B) as the condition
of consumers equilibrium.2
2.2 MEANING AND DETERMINANTS
OF DEMAND
Our analysis of consumers equilibrium
implies that the price of a product is an
important factor in determining how
much of the product a consumer will
be willing to buy within a given time
period. It is because, as the product
price changes, the ratio of marginal
utility to price changes so that the
consumers equilibrium will occur at a
different level of consumption.
21
This forms the basis of defining

demand for a particular good by a
consumer: it is the quantity of the
good that she is willing to buy at
different prices within a given period
of time.
However, the price of a product is
not the only factor that influences how
much a consumer should buy of that
product. For example, if there is a taste
change, it will change the marginal
utilities from a product, and, the
consumers equilibrium condition will
be fulfilled at some other level of
consumption even when there is no
change in price.
Moreover, while our preceding
analysis is confined to one good (e.g.
gol guppa), in reality, a consumer
buys many goods. The consumers
equilibrium analysis with respect to
many goods (which is outside our
scope) suggests two other factors,
namely, prices of related goods and
income. This is quite natural. If a
person consumes, for example, tea
and coffee, then a change in the price
of tea should affect her consumption
of coffee and vice versa. Also, if income
changes, different amounts can be
bought even when the prices of goods
and services she consumes remain
unchanged.
The last three factors just
mentioned
are
called
the
determinants of demand. They are
namely,
Nothing essential or important is gained by deviating from this assumption. The only modification is
that, when a good is not perfectly divisible, the condition (A) or (B) holds either exactly or approximately.
22
(a) prices of related goods,

(b) income and
(c) tastes. 3
The next question is how the own
price of a product as well as these three
factors affect the quantity demanded of
a particular good.
2.2.1 Own Price: The Law of
Demand
To isolate its effect, hold the other
factors constant and ask how the
quantity demanded of a product
changes as its own price changes. The
answer is summarised as what is called
the Law of Demand. It states that other
things remaining unchanged, as the
own price of a commodity increases,
the quantity demanded of it by a
consumer falls. Other things refer to
the prices of related goods, income and
tastes.
Suppose that, for a particular family,
within a month, Table 2.3 lists its
quantities demanded of apples at
different prices, which are consistent with
its consumers equilibrium. The left
column lists various prices, while the
right column lists the corresponding
quantities demanded. It is assumed that
the prices of related goods, family income
and tastes are kept fixed at some
pre-determined levels.
3
The law of demand in tabular form

is called a demand schedule. If we
graph a demand schedule, we obtain a
demand curve. It typically measures
own price along the y-axis and quantity
demanded on the x-axis. The demand
curve corresponding to the demand
schedule in Table 2.3 is shown in
fig. 2.1. We see that the demand curve
is downward sloping. It is because an
increase in the own price lowers the
Table 2.3
A Demand Schedule
Own Price
(in Rs.)
Quantity Demanded
of Apples
12
24
13
17
14
12
15
16
17
quantity demanded. Each point of the

demand curve shows the quantity
demanded that is consistent with
consumers equilibrium.
Why is the Demand Curve Downward
Sloping?
Isnt it obvious that the demand curve
is downward sloping? That is, as
Apart from (a), (b) and (c), there may be other determinants of demand for a good, e.g., future price
expectation. Consider an essential product, say, edible oil or sugar. Suppose there is a weather
prediction that your village or town will be hit by a severe cyclone in the next three days. You would
then anticipate that supply interruptions would occur and prices of these commodities would skyrocket. If you are a rational consumer, you would buy more of these commodities now (and store them)
even if prices, income or tastes do not change.
Moreover, taste changes can occur not only because of natural changes in a persons liking, but also due
to advertising of products.
CONSUMER CHOICE
AND THE
DEMAND CURVE
23
Table 2.4 Marginal Utility

Schedule and the Demand
Schedule
Fig. 2.1 Demand Curve Corresponding

to Table 2.3
the own price increases, the quantity

demanded of a product falls.
Interestingly, it is not. There is a reason
behind it, namely, the law of
diminishing marginal utility. Indeed,
the demand curve is essentially the
marginal utility curve.4
Consider Table 2.4, which lists the
marginal utility from consuming
T-shirts. Mark that, for simplicity,
diminishing marginal utility sets in with
the very first unit of consumption.
Assume further, again for simplicity of
exposition, that the marginal utility of
a rupee is equal to 1 util. Then, our
consumers equilibrium condition (A)
can be stated as Marginal Utility =
Price.
To begin with, suppose that the
price of a T -shirt is Rs. 45. The
consumers equilibrium condition
holds at 7 T-shirts consumed. This can
4
Quantity of
T-shirts
Marginal Utility of
T-shirts
75
70
65
60
55
50
45
be restated as follows. The quantity

demanded of T-shirts is 7 when the
price is Rs. 45. Thus the pair (45, 7)
will be on the demand curve. Similarly,
suppose that the price of T -shirts
increases to Rs. 65. The consumers
equilibrium condition now holds at 3
T-shirts consumed, that is, at price
Rs. 65, the quantity demanded is 3.
Hence the pair (65, 3) will be on the
demand curve too. Likewise, we can
determine that all other points on the
marginal utility schedule are points on
the demand schedule. This means that
the marginal utility curve itself is the
demand curve, and, the demand curve
is downward sloping because of the law
of diminishing marginal utility.
An intuitive way to see this is that, as a consumer buys more of a good, her marginal utility decreases
and therefore she is willing to pay less per unit. This can be turned around to say that if the price of a
product falls, a consumer buys more of it.
24
2.2.2
Determinants of Demand
Now turn to the remaining factors that

affect the quantity demanded of a
particular product, or, what we have
called the determinants of demand.
Change in Price of a Related Good
Suppose that Mrs. Das, who lives next
door to you, has a weakness for sweets.
Burfi and gulab jamun are her
favourites. Suppose that burfis become
more expensive: from Rs. 5 a piece to
Rs. 8 a piece. How will this affect Mrs.
Dass demand for gulab jamun? It will
increase. Why, because burfi and gulab
jamun are substitutes of each other in
consumption. Consider another
example: that of tea and coffee. The
same should happen to the demand for
tea if the price of coffee rises or vice
versa, because tea and coffee are also
substitutes. We say that good A is a
substitute of good B if an increase in
the price of good B increases the
demand for good A.
On the other hand, consider tea and
sugar. Sugar is complementary to tea
Table 2.5
in consumption. Thus, if the price of tea

goes up, the quantity demanded of tea
should fall, which will reduce the
demand for sugar. Another example of
a pair of complementary products is
petrol and cars. If the price of petrol rises,
the quantity demanded of cars should
fall. In other words, good A is said to be
complementary to good B if an increase
in the price of good B decreases the
demand for good A.
These examples illustrate cross
price effects: how the demand for one
particular product is affected by a
change in the price of another.
Numerical examples of cross price
effects are given in Tables 2.5 and 2.6.
In Table 2.5, note that as the price
of coffee rises from Rs. 200 to Rs. 250,
the quantity demanded of tea increases
for any given price of tea. For example,
given price of coffee = Rs. 200, at tea
price equal to Rs. 170, the quantity
demanded of tea is 11, whereas, given
coffee price = Rs. 250, at the same tea
price (Rs. 170), the quantity demanded
of tea is 18. The demand schedules of
Effect of an Increase in the Price of Coffee on Demand for Tea
Price of Tea
(per kg)
Rs.
Quantity Demanded of Tea

when Price of Coffee
(per kg) = Rs. 200
Quantity Demanded of Tea

when Price of Coffee
(per kg) = Rs. 250
150
20
28
170
11
18
190
10
210
230
CONSUMER CHOICE
Table 2.6
AND THE
DEMAND CURVE
25
Effect of an Increase in the Price of Tea on Demand for Sugar
Price of Sugar
(per kg)
Rs.
Quantity Demanded of
Sugar when Price of Tea
(per kg) = Rs. 170
Quantity Demanded of Sugar

when Price of Tea
(per kg)= Rs. 200
20
12
14
11
14
17
tea given in column (2) and (3) of

Table 2.5 are graphed in Figure 2.2.
We see that demand curve for tea
when the price of coffee is Rs. 250 lies
to the right of that when the price of
coffee is Rs. 200. Hence, an increase
(a decrease) in the price of a substitute
good shifts the demand curve for a
product to the right (left).
Similarly, in Table 2.6, notice that,
as the tea price increases from Rs. 170
to Rs. 200, the quantity demanded of
sugar decreases for any given price of
sugar. Figure 2.3 graphs Table 2.6.
The demand curve for sugar when tea
price is Rs. 200 lies to the left of that
when the sugar price is Rs. 170. Thus,
an increase (a decrease) in the price
of a complementary good shifts
the demand curve for a product to the
left (right).
A Change in Income
Suppose that you only buy peanuts
and ice cream from your pocket money.
Ice cream is your favourite but it is
costly. You like peanuts much less, but
Fig. 2.2
Change in demand due to increase

in the price of a substitute good
they are cheap. Suppose that your

pocket money increases. Will you buy
more of ice cream, more of peanuts or
both? We bet that you will buy more
ice cream. Whether you will buy more
peanuts is not clear. Very likely, you will
buy less of peanuts, not because your
taste changes but because you can
afford more ice cream, which is your
favourite.
Hence, generally, we can say that,
as income increases, a consumer may
26
buy more or less of a product. If she

buys more (e.g. ice cream), then we say
that the product in question is a normal
Fig. 2.3 Change in demand due to

increase in the price of a
complementary good
good. If she buys less (e.g. peanuts),

then we say that it is an inferior good.
Put differently, nor mal goods are
those, for which demand increases as
income increases. Inferior goods are
Table 2.7
Own Price
those, for which demand falls as

income rises.
Table 2.7 presents numerical
examples of both normal and inferior
goods. Observe that, at any given price,
as income increases, quantity
demanded of the normal good increases
(by comparing columns (2)-(3)) and that
of the inferior good decreases (by
comparing columns (5)-(6)). These are
graphed in figs. 2.4 and 2.5. The
original demand curve for the normal
good, when income is Rs. 300, is
indicated by the line NN0 in fig. 2.4.
This represents the column pair (1)-(2).
The new demand curve, when income
of Rs. 400, is marked by NN 1 that
represents the column pair (1)-(3).
Hence an increase in income shifts the
demand curve to the right if the good
is nor mal. For the inferior good,
the demand curves are indicated
by FF 0 (original) and FF 1 (new) in
Normal and Inferior Goods
A Normal Good
(Quantity
(Quantity
Demanded: Demanded:
Income =
Income =
Rs. 300
Rs. 400
An Inferior Good
Own Price
Quantity
Quantity
Demanded: Demanded:
Income =
Income =
Rs. 300
Rs. 400
15
19
20
15
12
16
17
12
13
14
11
11
CONSUMER CHOICE
AND THE
DEMAND CURVE
27
fig. 2.5. Thus an increase in income

shifts the demand curve to the left if
the good is inferior.
In the real world, there are much
fewer examples of inferior goods than
normal goods. Yet there are important
examples. In India, cereals as a single
category of goods (that includes rice,
wheat, bajra, jowar etc.) constitute an
inferior good. Within this category, the
inferior-good characteristic applies to
bajra, jowar, maize and related cereals.
A Change in Tastes
Finally, consider a taste change.
Suppose you are impressed by an
advertisement in TV, in which your
favourite actor drinks Coca Cola, and,
as a result, your liking for Coca Cola
increases. This will shift your demand
curve for Coca Cola to the right. This is
an example of a favourable change in
tastes. An unfavourable change in taste
will imply the opposite. We can then say

increase in income (Inferior Good)
that a favourable (an unfavourable)

change in tastes shifts the demand
curve to the right (left).
A taste change may result from a
change in a persons liking, or, from some
other source. If, for instance, for health
reasons, you have to consume more of a
product although you dont like it, this
is also considered a taste change.
2.2.3 Change
in
Quantity
Demanded Versus Change/
Shift in Demand

increase in income (Normal Good)
We have seen that the quantity

demanded of a product depends on
own price and other factors like
prices of related goods, income and
tastes. The law of demand refers to the
effect of a change in the own price. A
graphical representation of this is the
demand curve, which is downward
sloping. A change in the own price
causes a movement along a given
demand curve: higher (lower) the price,
less (more) is the quantity demanded.
28
Such a movement is called a change

in the quantity demanded.
In contrast, when a change in any
other factor causes a (left or rightward)
shift of a demand curve, we call this a
change in demand.
The distinction between the two
concepts is illustrated in fig. 2.6.
Fig. 2.6(a) illustrates a change in the
quantity demanded. There is a price
change from P0 to P1. As a result, there
is a movement along the same demand
curve from A to B. The quantity
demanded changes from Q0 to Q1. In
contrast, fig. 2.6(b) shows a change in
demand, meaning a shift of a demand
curve from DD0 to DD1 due to a change
in the prices of related goods, income
or tastes.
(a) Change in Quantity Demanded
2.3 MARKET DEMAND CURVE

We have studied consumers
equilibrium and the determinants of
demand for a good from the perspective
of a single individual. How do we get
the demand curve of a product by all
individuals together in an economy,
e.g., the economy of a region or a
country? The economy-wide demand
curve for a particular product is called
the market demand curve. It is
obtained by summing up the demand
curves across consumers or
households.
Consider the market for, say, gulab
jamun. Suppose that there are three
consumers in the market: Amar, Akbar
and Anthony. If at the price equal to
Rs. 3 a piece, Amar demands 5, Akbar
6 and Anthony 8 per week, then the
total quantity demanded is 19. Hence
(b) Change in Demand

Fig. 2.6 Change in Quantity Demanded
Versus Change in Demand
(3, 19) is a point on the market demand

curve. Repeat the same exercise for
other possible prices and obtain the
corresponding points. Plot the points,
join them and you get the market
demand curve.
A numerical example is given in
Table 2.8. Individual demand
schedules are given by column pairs
(1)-(2), (1)-(3) and (1)-(4). The column
CONSUMER CHOICE
AND THE
DEMAND CURVE
29
pair (1)-(5) gives the market demand

schedule. Note that for each row (price),
the entry in column (5) is the sum of
corresponding entries in columns (2),
(3) and (4).
These individual demand schedules
and the market demand schedule are
graphed in fig. 2.7. Amars, Akbars and
Anthonys demand curves are
respectively marked by their names.
The right most line is the market
demand curve. This is obtained by
horizontally summing the individual
demand curves.
What are the determinants of the
market demand curve? They are the
determinants of the individual demand
curve described earlier plus how many
consumers buy the product, that is,
(a) prices of related goods;
(b) income levels across individuals, or
Table 2.8
what we can call, the distribution

of income;
(c) consumers tastes
(d) the number of consumers who buy
the product, or what we can call, the
market size.5
2.4 PRICE
ELASTICITY
DEMAND
OF
We have seen how various factors like

own price and income affect the demand
for a commodity. The direction of
change was our focus - whether the
quantity demanded increases or
decreases as price, income or other
factors change. The concept of elasticity
captures the magnitude of change or
the degree of responsiveness. For
example, the price elasticity of demand
quantifies the effect of a change in own
price on the quantity demanded.
Individual and Market Demand Schedules for Gulab Jamun
Price of Gulab
Jamun in Rs.
Amars
Demand
Akbars
Demand
Anthonys
Demand
Market
Demand
15
13
35
10
10
26
19
14
10
Many multinational firms today look at the Indian or the Chinese market as very lucrative, because of
their market sizes, which refer to the huge number of consumers in these countries.
30
Fig. 2.7 Individual and Market Demand Curves
2.4.1 Definition and Formulas

Formally, Elasticity of demand is
defined as
(C ) Price elasticity of demand = e D
% change in the quantity demanded
=
% change in the own price
Since the changes in price and

quantity along a demand curve occur
in opposite directions, the ratio of %
change in quantity demanded and that
in the own price is negative in sign.
Hence attaching a negative sign in front
of the ratio makes the sign of eD positive.
Some other textbooks define the price
elasticity the same way as above, except
for the minus sign. But there is no
reason to get confused. Strictly speaking,
our definition gives the absolute value
of the elasticity, which is, often, referred
to as elasticity.
Along a given demand curve, let the

original price be P0 and the original
quantity be Q0. Suppose that the price
increases to P 1 and the quantity
demanded falls to Q1. Then the %
changes in price and quantity
demanded are respectively equal to
[(P1P0)/P0]100 and [(Q1Q0)/Q0]100.
Thus (C) can be written as
(D ) e D =
(Q1 Q0 ) / Q0
.
(P1 P0 ) / P0
If we further denote a change in

quantity as Q and a change in price
as P, we can also write
(E )
eD =
Q/Q0
.
P / P0
Consider the following numerical

example. Suppose that in your home
town, rasgoolas were being available at
Rs. 5.00 per piece and the residents of
CONSUMER CHOICE
AND THE
DEMAND CURVE
the town were buying 1200 rasgoolas

per day. Now they become more
expensive for some reason, at Rs. 5.50
per piece. Fewer people are eating
rasgoolas and many who eat, are eating
less. Suppose that the people in the
town are now buying 960 rasgoolas per
day. What is the price elasticity of
demand?
We have to do some arithmetic. The
% change in the price is equal to
[(5.50 5.00)/5.00] 100 =10. The %
change in quantity is equal to [(960
1200)/1200] 100 = 20. Hence, eD, the
price elasticity, is equal to 20/10 = 2.
Properties
1. A very desirable property of the
elasticity formula in measuring the
degree of responsiveness is that it
is independent of the choice of
units. It is because any percentage
change of a variable is independent
of units.
2. If two demand curves intersect, at
their point of intersection, the
elasticity associated with the
flatter demand curve is higher. This
is exhibited in fig. 2.8. The demand
curves DD and DD intersect at the
point C. At this point, P0 is the price
of the product. The claim is that, at
price P0, the elasticity is greater
along the flatter demand curve DD.
Why? Because the original quantity
demanded is the same, equal to D0,
along both demand curves, and, if
there is an increase in price, say to
P1, the quantity demanded falls
more along the flatter demand curve
(by amount D2D0 as compared to
31
D1D0 along DD). This implies that,

while the % change in price is the
same along both demand curves,
the % change in quantity demanded
is greater along DD. Therefore,
price elasticity associated with DD
is higher.
3. Higher the value of the price
elasticity, greater is the degree of
responsiveness of quantity
demanded to price. In particular, if
eD>1, then the % change in quantity
demanded must exceed the %
change in price. We then say that
the product demand is elastic (e.g.
jewellery). If eD<1, the % change in
quantity demanded is less than that
of the price, and, we say that the
product demand is inelastic.
Typically, the demand for luxury
goods is elastic and that for
necessary goods (e.g. basic food
items) is inelastic. Finally, if eD =1, it
is said that the demand is unitarily
elastic. In this special case, the
demand curve takes a particular
Fig. 2.8
Elasticity Comparison
32
shape, called rectangular hyperbola

in geometry. It is a curve, which
extends towards the x-axis and y-axis
in a uniform manner without
touching them. Fig. 2.9 exhibits this.
4. There are two other special cases. If
the product is absolutely essential,
like demand for a rare medicine or
some very bad case of addiction to
undesirable products like opium,
the demand curve is vertical. In this
case, the price elasticity is zero, i.e.,
the product demand is totally or
perfectly inelastic. This is evident,
because, along a vertical demand
curve, the quantity demanded is
totally insensitive to any change in
price. This case is exhibited in
fig. 2.10(a). The last special case is
the one, where demand curve is
horizontal and thus the demand is
perfectly elastic, i.e., the price
2.4.2 Factors
Affecting
the
Magnitude of Price Elasticity
In general, the magnitude of price
elasticity depends on the following
factors.
Availability of Close Substitutes: If
close substitutes of a product are
readily available, its price elasticity of
demand is likely to be high, because
even a very small increase in price will
make consumers switch to other
(a) Perfectly Inelastic Demand
Fig. 2.9
Unitarily Elastic Demand
elasticity is equal to infinity.

Fig. 2.10(b) shows this. An
economic example of this demand
curve will be given in Chapter 4.
(b) Perfectly Elastic Demand
Fig. 2.10
Elasticitiy = 0,
CONSUMER CHOICE
AND THE
DEMAND CURVE
products in a big way. Otherwise, in the

absence of close substitutes, the
elasticity is likely to be small. For
example, if it is a staple food item of a
particular region, say, rice in Orissa or
West Bengal, by definition, there are no
(very) close substitutes available. It is
indispensable. Hence the demand for
rice is likely to be inelastic. More
generally, the demand for essential
products is likely to be inelastic. On the
other hand, luxury items like eating
in a restaurant, buying a big-size
colour TV etc. are relatively dispensable.
Hence the demand for these items is
likely to be relatively elastic.
Proportion of Total Expenditure
Spent on the Product: If the amount
spent on a product constitutes a very
small fraction of the total expenditure
on all goods and services you consume,
then the price elasticity is likely to be
small. The demand for salt is an
example. On the other hand, if it is a
high-price item and takes a major
portion of your total expenditure, your
demand for it is more sensitive to a price
change; that is, the elasticity of demand
is likely to be high.
Habits: Some products which are not
essential for some individuals are
essential for others. A form of
consumption such as eating out in fivestar restaurants is a luxury for many
people; therefore, their demand for it is
very elastic. But, for someone who is
very rich, it may be an essential
demand, because he is already
habituated. Hence his demand for five-
33
star restaurant food is inelastic.

Similarly, for an opium addict, the
demand for opium is very inelastic,
whereas for other casual opium takers,
the demand is likely to be elastic.
Time Period: All other things remaining
the same, the longer the time period,
more elastic is the demand for any
product. The consumption of petrol is
a prime example. In the 1970s, when
OPEC (Organisation of Petroleum
Exporting Countries) dramatically
increased the price of oil for the first time
in history, the whole world was
shocked. Countries could not
immediately find and adopt any other
forms of energy for their needs. In other
words, substitutes of oil could not be
available and the demand for oil was
very inelastic. But over years alternative
types of energy were developed, and,
substitutes became more readily
available. The demand for oil is more
elastic today than it was 30 years ago.
Clip 2-1 reports price elasticities for
various products that have been
estimated by various authors.
2.4.3
Measurement of Elasticity
Finding price elasticity of demand

using its definition as such is called the
percentage method of measuring
elasticity. In particular, when the price
change is very small, a graphical
formula or a geometric method can
also be used to measure elasticity.
Suppose that it is a straight-line
demand curve, as shown in fig. 2.11,
having intercepts A and B respectively
on the price axis and quantity axis
34
Clip 2-1
Price Elasticity Estimates
Price elasticities have been estimated for various products and services and in
the context of different countries. Five examples are reported below, four of which
are for India and one for America.
As you see, the price elasticities for food items and clothing are less than one, as
these are essential items. Note that item No. 4 is an example of a service: long
distance phone calls from PCOs. The elasticity for this item is also less than one.
It indicates that long-distance telephone calls are not a luxury demand anymore;
they have become a necessity in a country like India.
The item no. 5 shows that the demand for residential land in America is elastic,
equal to 1.64.
Product/Service
Price Elasticity Estimate
Source
1.
Cereals & cereal

substitutes
(India)
0.544
Meenakshi and Ray

(1999)
2.
Other foods
(India)
0.804
Meenakshi and Ray

(1999)
3.
Clothing
(India)
0.560
Meenakshi and Ray

(1999)
4.
Long distance
phone calls
from Public
Call Offices
(India)
0.580
Das and Srinivasan

(1999)
5.
Residential
Land in
Philadelphia
(U.S.A.)
1.640
Gyourko and Voith

(2001)
Das, P. and P.V. Srinivasan, Demand for Telephone Usage in India,

Information Economics and Policy, 11, 1999, pages 177-194. Meenakshi, J. V.
and Ranjan Ray, Regional Differences in Indias Food Expenditure Pattern: A
Complete Demand Systems Approach, Journal of International Development,
11, 1999, pages 47-74. Gyourko, J. and R. Voith, The Price Elasticity of Demand
for Residential Land: Estimation and Some Implications for Urban Reform,
mimeo, Wharton School of Management, 2001.
CONSUMER CHOICE
AND THE
DEMAND CURVE
respectively. Suppose that initially the

price is P0, and the quantity consumed
is Q0, that is, the consumer is at point C
on the demand curve. Then, for small
price changes, the price elasticity turns
out to be equal to BC/AC. This
graphical formula is called point
elasticity. In other words, point
elasticity, at a certain point along a
straight-line demand curve, is equal to
the lower segment divided by the upper
segment of the demand curve at that
point.
A proof of it is given in Appendix 2.
The point elasticity formula implies
that, as price increases, the ratio of the
lower segment to the upper segment
increases (as we are looking at points
higher up on the demand curve) and
therefore the product becomes more
elastic.6,7,8
2.4.2 Total Expenditure and Price
Elasticity
The concept of price elasticity does not
just quantify the relationship between
price and quantity demanded, it also
indicates the direction in which the total
expenditure on a product changes, as
there is a change in price.
Return to the rasgoola example
and ask the following simple question.
Because of the increase in the price of
6
7
8
35
Fig. 2.11 Point Elasticity along a Straight

Line Demand Curve
rasgoolas, does consumer spending or

total expenditure on rasgoolas increase
or decrease? By definition, the total
expenditure on a particular good =
price quantity. If we denote total
expenditure by TE, price by P and
quantity by Q, then TE = PQ. Let us now
calculate TE. Originally, P and Q were
respectively Rs. 5.00 and 1,200; hence
TE was equal to Rs. 6,000. At the new
price Rs. 5.50 and quantity = 960, TE
= Rs. 5,280. Thus the total expenditure
has fallen. Note also that the elasticity
is equal to 2. That is, in the example,
the demand for rasgoola is elastic, and,
as there is a price increase, the total
expenditure falls.
This is not a general property of price elasticity. It may not hold when the demand curve is not a straight
line.
At point B the elasticity is zero and at point A it is infinity.
If it is not a straight-line demand curve, then the point elasticity measure at a point on it is based on
the tangent to the curve at that point. You will find a treatment of this in a higher-level micro economics
textbook.
36
It turns out that such opposite

movements in the directions of price
and total expenditure changes hold, not
just in this example, but always, when
the product demand is elastic. Similarly,
if the product demand is inelastic, the
total expenditure always increases as
price increases. Moreover, as a special
case, if the product demand is unitarily
elastic, then the total expenditure does
not change with any price change. You
can relate the last case to fig. 2.9, which
depicts the unitarily-elastic case. That
is, the total expenditures at all points
on that demand curve are the same.
There is thus a general relationship
between the direction of price change
and the direction of change in total
expenditure, depending on the
magnitude of price elasticity. If the
product demand is elastic, unitarily
elastic or inelastic, an increase in price
leads respectively to a decrease, no
change or an increase in the total
expenditure on the product. Table 2.9
presents this result in a tabular form.
This result can be proven
algebraically, but it is beyond our
Table 2.9
scope. However, it is quite intuitive. If

the demand for a product is elastic, it
means that a small price change invites
a relatively large adjustment in the
quantity. Hence the total expenditure
must change in the same direction in
which the quantity changes. Now you
see that, as price increases, quantity
falls and the fall in quantity is associated
with a fall in the total expenditure. Just
the opposite holds when the product
demand is inelastic. In this case a large
price change leads only to a relatively
small adjustment in quantity. Hence the
total expenditure must change in the
same direction as the price change, i.e.,
a price increase leads to an increase in
total expenditure.
So far we have discussed how we
can determine the direction of change
in total expenditure, given the direction
of change in the price and given
whether the product is elastic or
inelastic. Alternatively, if we know the
direction of change in price and the
direction of change in total expenditure,
we can infer whether the product
demand is elastic or inelastic. For
Price Change and Its Effect on Total Expenditure
Price Change
Elasticity
Total Expenditure
eD > 1
eD > 1
eD < 1
eD < 1
eD = 1
No Change
CONSUMER CHOICE
AND THE
DEMAND CURVE
instance, if because of a price increase,

the total expenditure increases, then
the product demand must be inelastic.
You can readily verify that from Table
2.9.
This link, via price elasticity, between
changes in price and total expenditure has
important practical implications. Return
once again to the rasgoola example.
Suppose that there is only one (giant)
halwai shop in town, who sells rasgoolas.
If you are the halwai shop owner and are
37
thinking about increasing the price of

rasgoola, wouldnt you want to know if a
price increase would increase or decrease
your total sales in rupees? From a sellers
perspective, the total value of sales is
usually called total revenue and note that
total revenue is equal to the total
expenditure by the consumers.9 Hence
the relationships between elasticity, price
change and total expenditure are
important from the viewpoint of decision
making by a producer or a firm.
SUMMARY
Total utility is equal to the sum of marginal utilities.
A rational consumer will never consume that much of a product such

that the marginal utility from it is negative.
At the consumers equilibrium, the difference between total utility in

terms of money and the total expenditure on a good is maximised.
Consumers equilibrium is attained when the condition that the

marginal utility in terms of money is equal to the price is met.
The law of demand defines demand curve, which is downward sloping.
The demand curve is downward sloping because of the law of

diminishing marginal utility.
The demand curve is essentially same as the downward sloping portion

of the marginal utility curve.
A shift of the demand curve is caused by a change in the prices of related

goods, a change in income or a change in tastes.
An increase in the price of a substitute good causes an increase in

demand or a rightward shift of the demand curve, while an increase in
the price of a complementary good causes a decrease in demand or a
leftward shift of the demand curve.
As income increases, the demand for a product increases or decreases,

i.e., the demand curve shifts to the right or left, depending on whether
the good is normal or inferior.
We will see the use of the term total revenue in Chapters 4, 6 and 7.
38
A favourable taste change increases the demand for a good, i.e.,

shifts the demand curve to the right; an unfavourable change does
the opposite.
Market demand curve is obtained by horizontally summing up

the individual demand curves.
The determinants of market demand curve are prices of related

goods, distribution of income, tastes and the market size.
The price elasticity of demand is independent of the choice of units.

When two demand curves intersect, the elasticity associated with
the flatter demand curve is greater.
Greater the availability of close substitutes of a product, the higher
is the price elasticity of demand for a product.
Typically, the demand for luxury products is elastic and that for
necessary goods is inelastic.
Greater is the share of the total budget spent on a particular good,
the more elastic is the demand for it.
Longer the time horizon, the more elastic is the demand for a
product.
If the demand curve is vertical (horizontal), the price elasticity is
zero (infinity). In case of elasticity equal to one, the demand curve
is a rectangular hyperbola.
l
l
l
l
l
l
Given that the demand is a straight line, the point elasticity is

equal to the lower segment divided by upper segment of the
demand curve at that point.
If demand is elastic (inelastic), an increase in the price of the

product leads to a decrease (an increase) in the total expenditure
on the product.
In case of a unitarily elastic demand, a change in price leaves the

total expenditure on the product unchanged.
EXERCISES
Section I
2.1
2.2
Define total utility.

Define marginal utility.
CONSUMER CHOICE
AND THE
DEMAND CURVE
39
2.3
How is total utility derived from marginal utilities?
2.4
State the law of diminishing marginal utility.
2.5
Give the meaning of demand.
2.6
Name two determinants of the demand.
2.7
List the factors that cause changes in demand.
2.8
What is the law of demand?
2.9
What is a demand schedule?
2.10
Give an example of a pair of commodities that are substitutes of

each other.
2.11
Give an example of a pair of commodities such that one of them

is complementary in consumption to the other.
2.12
If the price of good X rises and it leads to an increase in demand

for good Y, how are the two goods related?
2.13
If the price of good X rises and this leads to a decrease in demand

for good Y, how are the two goods related?
2.14
Define price elasticity of demand.
Section II
2.15
2.16
A persons total utility schedule is given below. Derive her

marginal utility schedule.
Amount Consumed
Total Utility
10
25
38
48
55
A persons marginal utility schedule is given below. Derive her

total utility schedule. (Assume that the total utility of consuming
zero is zero.)
40
2.17
2.18
2.19
2.20
2.21
2.22
2.23
2.24
2.25
2.26
2.27
2.28
2.29
2.30
2.31
Amount Consumed
Marginal Utility
10
What is consumers equilibrium.

State the condition of consumers equilibrium.
Starting from an initial situation of consumers equilibrium, suppose
that the marginal utility of a rupee increases. Will it increase or
decrease the quantity demanded of the product?
Ice creams sell for Rs. 30. Lakhmi, who loves ice cream, has already
eaten 3. Her marginal utility from eating 3 ice creams is 90. Suppose
further that, for her, the marginal utility of one rupee is 3. Should
she eat more ice cream or should she stop?
Explain the determinants of demand.
What is meant by cross price effects? Give two numerical examples
to illustrate this.
What is meant by one good being a substitute of another?
What is meant by one good being complementary to another?
Differentiate between substitute and complementary goods.
How will an increase in the price of coffee affect the demand for tea?
How will an increase in the price of tea affect the demand for sugar?
Suppose that good A is a substitute of good B. How will an increase
in the price of good B affect the demand curve for good A?
Suppose that good A complementary to good B in consumption.
How will an increase in the price of good B affect the demand curve
for good A?
Give two examples of normal goods and two examples of inferior
goods.
How does an increase in income affect the demand curve for a normal
good?
CONSUMER CHOICE
AND THE
DEMAND CURVE
41
2.32
How does an increase in income affect the demand curve for an

inferior good?
2.33
Define (a) complementary goods, (b) substitute goods, (c) inferior

good and (d) normal good.
2.34
Distinguish between a change in quantity demanded and a

change in demand.
2.35
How is the market demand curve derived from the individual

demand curves?
2.36
There are four consumers of a fruit called Smile. They are Isha,
Ifraah, Ila and Ibema. Their demand curves for Smile are given
below. Derive the market demand curve.
Price
Quantity
(Rs.) Demanded by
Isha
Quantity
Quantity
Quantity
Demanded by Demanded by Demanded by
Ifraah
Ila
Ibema
16
15
11
12
2.37
2.38
2.39
2.40
2.41
Explain the determinants of the market demand curve.

Distinguish between individual and market demand curves.
Originally, a product was selling for Rs. 10 and the quantity
demanded was 1000 units. The product price changes to
Rs. 14 and as a result the quantity demanded changes to 500
units. Calculate the price elasticity.
Which of the following commodities have inelastic demand? Salt,
a particular brand of lipstick, medicine, mobile phone and school
uniform.
Draw diagrams showing elasticity equal to (a) zero, (b) one and
(c) infinity.
42
2.42
2.43
2.44
2.45
2.46
2.47
2.48
2.49
2.50
Draw a straight line demand curve. Choose any three points on

it and compare the point elasticities at these three points.
Consider the above straight line demand curve. Compare the
point elasticities between the points A, B and C.
The price elasticity is 2. The % change in price is equal to 5.
Find the % change in quantity.
The price elasticity is 0.5. The % change in quantity is 4. What
is the % change in price?
As the price of peanut packets increases by 5%, the number of
peanut packets demanded falls by 8%. What is the elasticity of
demand for peanut packets?
As the price of a product decreases by 7%, the total expenditure
on it has gone up by 3.5%. What can we say about the elasticity
of demand for this product?
The price of cauliflower goes up by 8% and the total expenditure
by a family on cauliflower goes up by 8%. What can we say
about the elasticity of demand for cauliflower by this family?
Show the effect of an increase in price on total expenditure
depending on the values of price elasticity.
A dentist was charging Rs. 300 for a standard cleaning job and
per month it used to generate total revenue equal to Rs. 30,000.
She has since last month increased the price of dental cleaning
to Rs. 350. As a result, fewer customers are now coming for
dental cleaning, but the total revenue is now Rs. 33,250. From
this, what can we conclude about the elasticity of demand for
such a dental service?
CONSUMER CHOICE
2.51
2.52
AND THE
DEMAND CURVE
43
If a product price increases, a familys spending on the product

has to increase. Defend or refute.
Determine how the following changes (or shifts) will affect market
demand curve for a product.
(a) A new steel plant comes up in Jharkhand. Many people who
were previously unemployed in the area are now employed.
How will this affect the demand curve for colour TVs and
Black and White TVs in the region?
(b) In order to encourage tourism to Goa, the Government of
India suggests Indian Airlines to reduce air fare to Goa from
the four major cities, Chennai, Kolkata, Mumbai and New
Delhi. If the Indian Airlines reduces the air fare to Goa, how
will this affect the market demand curve for air travel to Goa?
(c) There are train and bus services between New Delhi and
Jaipur. Suppose that the train fare between the two cities
comes down. How will this affect the demand curve for bus
travel between the two cities?
Section III
2.53
2.54
2.55
Discuss how the market demand curve is derived from the

individual demand curves and the determinants of market
demand.
Explain why consumers equilibrium is attained when the
marginal utility of a product in terms of money is equal to its
price.
Suppose there are three consumers in a particular market:
Leander, Andre and Tim. Their demand schedules are given in
the following table.
Price Quantity Demanded Quantity Demanded Quantity Demanded

by Leander
by Andre
by Tim
1
60
55
24
50
40
13
40
25
30
10
20
44
2.56
2.57
(a) Derive the market demand schedule and plot the market demand
curve.
(b) Suppose Andre drops out of the market. Derive the new market
demand curve.
(c) Suppose Andre stays in the market and another person, Marat, joins
the market, whose quantity demanded at any given price is half of
that of Leander. Derive the new market demand curve.
Why does the demand curve slope downwards?
Explain the factors affecting the magnitude of price elasticity of demand.
PRODUCTION
AND
COSTS
U N I T- I I I
PRODUCER BEHAVIOUR
AND SUPPLY
45
46
CHAPTER
PRODUCTION
3.1 Production
3.2 Costs
AND
COSTS
In Chapter 2 we studied the consumers

behaviour. In Chapters 3 and 4 we will be
concerned with the producers behaviour. In
this chapter in particular, we study important
concepts associated with production and
costs.
A producer or a firm is in business to
maximise profit.1 By definition, profit earned
by a firm is equal to its total revenues minus
the total costs. As an example, suppose that
you are in the business of making hammers,
and, during a month, you produce and sell
500 hammers. They are selling at the price of
Rs. 20 each. Then the total revenues
generated are equal to price quantity, that
is, Rs. 20 500 = Rs. 10,000.
Producing hammers requires inputs such
as labour, building, equipment and raw
materials. This is a technological relationship.
In turn, inputs have to be paid. The sum total
of payments to all inputs is the total cost of
production. Let the total cost of making 500
hammers over the month be Rs. 6,500.
Then your profit is equal to Rs. 10,000
Rs. 6,500 = Rs. 3,500.
In this chapter and others, we will use the term profit

or profits. Both are correct uses.
PRODUCTION
AND
COSTS
47
The above example is illustrative of

some important linkages. On one hand,
the amount produced, or, what is called
output, is linked to total revenues in
the product market. On the other hand,
output is linked to inputs via
technology, which is called production
function (to be defined in a moment),
and, the employment of inputs leads to
their payments. This chain links output
to costs.
Fig. 3.1
Linkages
These linkages are depicted in

fig. 3.1. In Section 3.1, we will study
the relationship between inputs and
output. In section 3.2, we will analyse

that between output and payments to
inputs. The link between output and
revenues will be examined in Chapter
4 (and in Chapter 6 also).
3.1 PRODUCTION
3.1.1 Production Function
The most basic concept here is what
is called the production function,
defined as a technological relationship
that tells the maximum output
producible from various combinations
of inputs.
For instance, a firm employs only
two factors or inputs, say, labour
(measured in hours) and land (in
acres), and, Table 3.1 lists some factor
combinations and the corresponding
output levels. 1 hour of labour and
2 acres of land produce at the most
5 units output, 2 hours of labour and
4 acres of land produce at the most
Table 3.1 Production Function

Labour
(in hours)
Land
(in acres)
Output
(in units)
11
18
24
10
30
12
35
14
40
48
11 units of output, and so on. It is

normally assumed that inputs work to
the best of their efficiency. Hence,
instead of maximum output, we just
say output, e.g., 2 hours of labour
combined with 4 acres of land produce
11 units of output.2
Note that the notion of production
function is not just confined to two
inputs. There can be other inputs like
capital, raw material etc.3
3.1.2 Returns to an Input
A production function given in the
tabular form such as in Table 3.1 does
not reveal much about the contribution
of a single factor towards production.
A reasonable way to assess this will be
to vary the employment of one input
while keeping the employment of other
inputs fixed. Three concepts arise in this
experiment.
One is total product or total
physical product, denoted by TPP. It
simply defines the total output at a
particular level of employment of an
input when the employment of all
other inputs is unchanged. The next
one is marginal product or marginal
physical product (MPP). This is
defined as the increase in the total
physical product per unit increase in
the employment of an input when the
employment of other inputs is given.4
When the employment of an input
changes, we call it a variable input.
2
3
4
Finally, we define Average Product

or Average Physical Product (APP) as
the TPP per unit employment of the
variable input, i.e., APP = TPP/L, where
L is the level of employment of the
variable input.
These are also respectively called
total, marginal and average returns
to an input.
A numerical example showing a
TPP schedule is given in Table 3.2,
where the variable input, L, is called
labour. If we graph a TPP schedule, we
get a total physical product curve.
Table 3.2 A Total Physical
Product Schedule
Labour Hours
employed (L)
Total Physical
Product (TPP)
10
22
33
43
51
56
56
48
36
Table 3.1 gives only some, not all, possible combinations of inputs and output.
Also, we can differentiate between unskilled labour and skilled labour.
These are respectively similar to the concepts of total utility and marginal utility discussed in Chapter 2.
PRODUCTION
AND
COSTS
49
Fig. 3.2 shows the TPP curve for the TPP

schedule given in Table 3.2.
Fig. 3.2 The Total Physical Product Curve

Corresponding to Table 3.2
The marginal physical product,

MPP, is derived from the total physical
product, TPP, just as marginal utility is
obtained from total utility. For instance,
Table 3.3
the MPP at L = 2, which is 12, is equal

to the difference between TPP at L = 2,
which is 22, and TPP at L = 1, which is
10. The MPP schedule corresponding
to the TPP schedule in Table 3.2 is given
in column (2) of Table 3.3. Likewise, the
APP schedule, given in column (3) of
Table 3.3, is obtained through dividing
TPP by L in Table 3.2. The graphs of an
MPP schedule and an APP schedule are
respectively called the marginal
physical product curve and the
average physical product curve. These
graphs corresponding to Table 3.3 are
given respectively in figs. 3.3 and 3.4.
Note the following :
1. It is not true that the concepts of
TPP, MPP and APP are applicable to
Marginal Physical and Average Physical Product Schedules
Labour
Hours
employed (L)
Marginal
Physical
Product (MPP)
Average
Physical
Product (APP)
10
10
12
11
11
11
10
10.75
10.20
9.33
-8
-12
50
one particular input (e.g. labour)

and not to others (e.g. land or
Fig. 3.3
Fig. 3.4
The Marginal Physical Product

Curve Corresponding to Table 3.3
The Average Physical Product

Curve Corresponding to Table 3.3
equipment). It is applicable to all

inputs, but one at a time.
2. Since MPPs are additions to the TPP,
TPP is the sum of MPPs ( just as total
utility is the sum of marginal
utilities). For example, in Table 3.2,
the TPP at L = 3 is equal to 33. In
Table 3.3, the MPPs at L = 1, 2 and
3 add up to 33.
3. The MPPs being additions to the
TPP also implies that if MPP is
positive, TPP must be increasing
and if MPP is negative, TPP must
be decreasing as the level of the
variable input increases. This

relationship is verified from TPP
and MPP schedules. In Table 3.2,
TPP increases up to L = 6; from
Table 3.3, we see that MPP is
positive in this range. In Table 3.2,
TPP decreases from L = 8 onwards;
in Table 3.3, MPP is negative in this
range.
4. Although we have derived MPP and
APP from TPP above, in general,
given any one of these, we can
derive the other two. Suppose
MPPs are given to us. Then we can
get TPP by adding MPPs (as TPP is
the sum of MPPs). Once we get TPP,
we can readily obtain APP by
applying its definition. Similarly, if
the APPs are known, we get TPP
by multiplying APP with the level
of employment. Then MPPs are
obtained by applying its definition.
Law of Variable Proportions and Law
of Diminishing Returns
As we will see later in this chapter and
in the next, the most important
schedule (curve) from our viewpoint is
the marginal physical product schedule
(curve). We notice from fig. 3.3 that the
MPP initially increases with an increase
in the employment of the input in
question, then it diminishes and finally
it becomes negative. This pattern of MPP
is called the Law of Variable
Proportions. Put differently, this law
outlines three stages of production. In
stage I, when the level of an inputs
employment is sufficiently low, its MPP
increases. In stage II, it decreases but
remains positive, and, finally, in stage
PRODUCTION
AND
COSTS
III, it becomes negative. In our example,

stage I holds till L = 2, stage II is
operative between L = 3 and L = 7, and,
stage III sets in at L = 8.
Note that in stages I and II, TPP
increases with the employment of the
variable input as MPP in this range is
positive. But in stage III, it decreases
since MPP is negative.
Closely associated with this law is
another important law, called the law
of diminishing marginal product or
the law of diminishing marginal
returns (which is similar to the law of
diminishing marginal utility). More
briefly, it goes by the name of the law
of diminishing returns. This says
that, the employment of other inputs
remaining the same, as more of a
particular input is used in production,
after a certain level, its marginal
physical product decreases with
further employment of it.
Fig. 3.5 illustrates these laws more
clearly. Suppose that the input can be
measured continuously like points on
a line, not just in integer units like 1,
2, 3 etc. Then the resulting TPP, MPP
and APP curves will look smooth. A
smooth MPP curve is drawn in fig. 3.5.
We observe that the MPP increases
between 0 to A. This region marks stage
I. The MPP diminishes but remains
positive between A to B, which marks
stage II. From the point B onwards, it
is the stage III, wherein the MPP is
negative. Diminishing returns holds in
stages II and III.
The reason behind the law of
variable proportions or the law of
diminishing returns is fundamentally
51
the same. As the employment of a

particular input gradually increases
while all other inputs are kept
unchanged, the factor proportions
become initially more suitable for
production, but, after a certain level,
the variable factor can work with other
given inputs only less efficiently, that
is, factor proportions become
increasingly
unsuitable
for
production.
The significance of these stages of
production is that a profit-maximising
firm will never operate in stage III. It is
because, by entering stage III, a firm
will have to incur higher costs on one
hand (as it is hiring more of the input),
and, at the same time, since output is
falling, in the output market, it will get
less revenues. This implies that profits
will be less.
It is not obvious at this point, but
we will learn in Chapter 7 that a profit-
Fig. 3.5 Three Stages of Production and

Diminishing Returns
maximising firm will not operate in

stage I either. That leaves out only stage
II, in which the marginal returns to an
52
input is positive but diminishing. From

the viewpoint of the operation of the firm,
this is the most relevant stage.
Finally, note that the law of
diminishing returns implies that the
MPP curve is inverse U-shaped. In
turn, this implies that the APP curve
is inverse U-shaped also.
3.1.3
Returns to Scale
Suppose that, instead of increasing

one input at a time, you increase the
employment of all inputs by the same
proportion (e.g. by 20%). The effect
of this change on output is captured
by the notion of returns to scale. Of
course, the output is going to
increase. But by how much? Will it
increase (a) by more than 20%,
(b) by less than 20% or (c) exactly by
20%? The possibilities (a), (b) and (c)
respectively illustrate increasing
returns to scale, decreasing or
diminishing returns to scale and
constant returns to scale.
In other words, suppose all inputs
are increased by a given proportion.
Increasing (respectively decreasing)
returns to scale hold when output
increases more (respectively less) than
proportionately. Constant returns to
scale hold when output increases
exactly by the proportion in which
inputs are increased.
You should not make the mistake
that the ter ms decreasing,
diminishing or constant mean that
the output decreases or remains
5
constant: the output always increases

when all inputs are increased.5
The production function outlined
in Table 3.1 contains stages showing
all three types of returns to scale. For
example, from B to D there are
increasing returns to scale. Why? In
combination B, 1 unit of labour and 2
units of land produce 5 units of
output. Compared to B, the
combination C has double the amount
of each input, but output (equal to 11)
is more than double of the output at
combination B. Similarly, from C to D,
inputs increase by 50% but output
increases by more than 50% (as 18 is
more than 50% higher than 11).
Likewise, you can calculate that,
in the range from D to F, there are
constant returns, and, finally from F
onwards there are decreasing returns
to scale.
3.2 COSTS
We now move on to discuss some cost
concepts. As fig. 3.1 suggests, cost
concepts are very much related to
concepts associated with the production
function. This point will be clearer as
we go along.
3.2.1
Short Run
Fixed and Variable Costs

At a given point of time, a firm faces
two types of costs: fixed costs and
variable costs. Fixed costs are those
that do not vary with the level of
output. (These are also called overhead
This holds as long as the MPP of each factor is positive, i.e., the firm is not operating in stage III.
PRODUCTION
AND
COSTS
costs.) For example, you operate a

garment factory. You pay a fixed rent
for the factory building, fixed insurance
payments for your machinery against
fire etc. These are independent of how
many garments per month you
produce.
There is a time element in
interpreting these costs as fixed. That
is, even if these costs are fixed at any
given point of time or within a short
time period, in a long run horizon, you
can think of renting more or less space,
having more or less number of
machinery depending on your
business outlook for the future. Hence
the rent and insurance costs etc. that
are fixed in the short run can vary in
the long run. In other words, fixed costs
are present only in the short run, not
in the long run.
Note that these notions of short run
and long run do not refer to any
particular calendar time. They refer
only to different periods of planning
horizon by producers in an industry.
Hence, they can vary from one industry
to another.
Having noted this difference, we
return to the short run situation.
Besides fixed cost, there are variable
costs those that change with the level
of output, e.g., labour costs and costs
of raw materials. If you want to
produce more garments, you have to
buy more cotton and other raw
materials, hire more workers and so
on. Variable costs increase with
output.
Instead of being termed simply fixed
and variable cost, these are formally
53
called Total Fixed Cost (TFC) and

Total Variable Cost (TVC). Total cost
(TC) is then, by definition, total fixed
costs + total variable costs. Table 3.4
presents a numerical example. Notice
that TFC, given in column (2), do not
change with output. But TVC, given in
column (3), does. The columns (2) and
(3) against column (1) are respectively
total fixed cost and total variable cost
schedules.
Graphs of these schedules are the
total fixed cost curve and the total
variable cost curve respectively.
Figure 3.6 depicts these, together
with the total cost curve that graphs the
TC schedule, given in the last column
of Table 3.4. The TFC curve is horizontal
because fixed costs do not change with
the output. However, since TVC and TC
increase with the output, these curves
are upward sloping. By definition, the
total cost curve is the vertical
summation of the total fixed and total
variable cost curves. Notice that, at the
zero level of output, TC = TFC, because
TVC is zero when output is zero.
Average Costs
If we divide total fixed cost and total
variable cost by output, we respectively
get the Average Fixed Cost (AFC) and
the Average Variable Cost (AVC). That
is, AFC = TFC/Output and AVC = TVC/
Output. Similarly, by dividing total cost
by output, we obtain the Average Total
Cost (ATC), i.e., ATC = TC/Output. Note
that, by definition, ATC = AFC + AVC.
Average total cost is sometimes loosely
called average cost only. The AFCs, the
AVCs and the ATCs corresponding to
54
Table 3.4
Total Fixed Costs and Total Variable Costs
Output
Total Fixed Costs

(Rs.)
Total Variable Costs

(Rs.)
Total Costs
(Rs.)
10
10
10
18
10
13
23
10
16
26
10
20
30
10
26
36
10
35
45
10
47
57
10
63
73
10
83
93
ATC curves slope downwards initially

and then upwards, i.e, they are
U-shaped. The reason behind this
shape will be discussed later.
Marginal Costs
Fig. 3.6
TFC, TVC and TC Curves

corresponding to Table 3.4
Table 3.4 are given in Table 3.5, and

fig. 3.7 graphs them. The AFC curve
continuously decreases as output
increases, because the numerator of the
ratio TFC/Output is constant while the
denominator increases. The AVC and
There is another important cost

concept, the marginal cost (MC). Similar
to marginal utility or marginal product,
this is defined as the increase in total
cost when one extra unit is produced.
Thus, it is the (additional) cost of
producing an extra unit. In the example
given in Table 3.4, suppose that the
current level of output is 7. The MC of
this output level is Rs. 12. It is because
the 7th unit of output costs Rs. 57
Rs. 45 = Rs. 12. The MC schedule
corresponding to Table 3.4 is given in
Table 3.6.
PRODUCTION
AND
COSTS
Table 3.5
Output
55
AFC, AVC and ATC Schedules (Based on Table 3.4)

AFC (Rs.)
AVC (Rs.)
ATC (Rs.)
10
18
6.50
11.50
3.33
5.33
8.66
2.50
7.50
5.20
7.20
1.66
5.84
7.50
1.43
6.71
8.14
1.25
7.875
9.125
1.11
9.22
10.33
Fig. 3.7 AFC, AVC and ATC Curves

Corresponding to Table 3.5
Note that, since total costs and

total variable costs differ only by a
constant term (equal to the total fixed
cost), MC can be equivalently defined
as the increase in the total variable
cost when one extra unit is produced.
Moreover, TVC is equal to the sum of
MCs (just as total utility is the sum of

marginal utilities). For example, the
TVC of producing 2 units is Rs. 13,
and, this is the sum of the MC of
producing one unit (= Rs. 8) and that
of producing two units (= Rs. 5).
Fig. 3.8 graphs the MC schedule
given in Table 3.6. It is the marginal cost
curve.
Assuming that the output is
per fectly divisible, a smooth
(hypothetical) marginal cost curve is
drawn in fig. 3.9. Recall that the TVC
is sum of the marginal costs. This
implies a property associated with a
smooth marginal cost. That is, the TVC
is equal to the area under the marginal
cost curve. For example, at output q0 ,
the TVC is equal to the area 0ABq0 .
This result will be used in Chapter 4.
56
As you see from fig. 3.8 or fig. 3.9,

the MC curve is initially decreasing in
output and then it is increasing, i.e, it
is U-shaped. The reason behind the Ushape of the MC curve is the law of
diminishing returns. As you recall, this
law says that, as other inputs are kept
Table 3.6
Marginal Costs (based

on Table 3.4)
Output
Marginal Cost (Rs.)
12
16
20
Fig. 3.9
Costs
in Rs
.
25
MC
20
15
10
5
0
0
unchanged, an increase in any given

input leads first to an increase in its
marginal physical product, and, then,
after certain point, leads to a decrease
in its marginal physical product. Let us
suppose that this particular input is
the only variable input, so that the total
payment to it is equal to the total
variable cost. Similarly, interpret the
other inputs, which are kept
unchanged, as the fixed factors, the
total payment to which is the total fixed
cost.
10
Output
Fig. 3.8 The MC Curve corresponding to

Table 3.6
A Smooth Marginal Cost
Let us now turn around the

statement of the law of diminishing
returns and say equivalently that, as
more and more output is produced,
initially, the rate of increase in the
requirement of the variable input will
be less and less, and, after a certain
point, it will be more and more. This
implies that, initially, the rate of increase
in the variable cost which is same as
the marginal cost will be less and less
as output increases, and then, it will
be more and more when output
PRODUCTION
AND
COSTS
increases further. This explains the Ushape of the MC curve.6

Once we know that the MC curve
is U-shaped, it follows that the AVC
and the ATC curves are U-shaped also.
There is indeed another relationship
that holds between AVC, ATC and MC
curves. Consider fig. 3.10, which
depicts smooth AVC, ATC and MC
curves. Observe that the MC curve cuts
the AVC and ATC curves at their
minimum points. The reason behind
this is mathematical, not economic,
and, it can be understood through the
following example.7
Consider the game of cricket.
Suppose that you are interested in
calculating the average score of
batsmen out as wickets continue to fall.
Begin to calculate this after, say, 3
wickets are down. The runs scored by
those already out are say 40, 105
and 2. The average is (40 + 105 + 2)/3
= 49. The game goes on and the fourth
wicket falls. You calculate the average
again and find that it has increased
from 49 runs. Has then the fourth
batsman, who got out, scored more or
less than 49? The answer is more.
Why, because otherwise the average
wouldnt have increased. Similarly, if the
average had fallen from 49, the fourth
batsman must have scored less than
49. This simple deduction means the
following.
Think of the runs scored by the
fourth batsman out as marginal (i.e.
6
7
57
Fig. 3.10
AVC, ATC and MC Curves
additional runs scored by the next

unit or batsman, when 3 are already
out). We are then saying that if the
average increases (respectively
decreases), the marginal should be
above (respectively below) the average.
Now go back to fig. 3.10. The AVC
curve is decreasing in the range of
output from 0 to q0. Then it must be
true that, (a) at any output level in this
range, MC < AVC. Likewise, (b) at any
output greater than q 0 , AVC is
increasing in output; hence MC > AVC.
Now, statements (a) and (b) together
imply that the MC curve must cut the
AVC curve at the AVCs minimum point.
By definition, MC is the addition to
both the TVC and the TC. Hence the
above logic applies to the relationship
Indeed, the MC curve is a mirror reflection of the MPP curve.

This is contained in Richard Manning and Kenneth Henry, The Logic of Markets, The Dunmore Press
Limited, New Zealand, 1983, Chapter 7.
58
between MC curve and ATC curve also.

The former cuts the latter at its
minimum point too.
3.2.2 Long Run
Recall that, in the long run, all inputs
are variable, because costs that are
fixed in the short run can be changed
if the planning horizon of the
producer
is
long
enough.
Accordingly, there are no TFC or AFC
curves in the long run. There is no
distinction between total costs and
total variable costs; we simply use
the term total costs. Similarly, there
is no distinction between average
total costs and average variable costs
and we will use the term long-run
average cost, denoted by LAC, where
L stands for long run. The concept of
marginal cost remains exactly the
same however; we will abbreviate it
to LMC.
In what follows, we discuss the
shapes of the LAC and LMC curves, the
reasons behind their shapes and the
relationship between them.
Like the short run average and
marginal cost curves, the LAC and LMC
curves, in general, are U-shaped, and,
the LMC curve cuts the LAC at its
minimum point. However, the reason
behind the U-shape is not the law of
diminishing returns. Instead, since all
inputs are variable, it is the pattern of
the returns to scale, which determines
the U-shape of these curves. 8
8
In particular, increasing returns to

scale mean that if output is increased
at a given rate (say 10%), inputs need
to be increased only by less than
proportionately (say by 7%). This
implies that the average cost must fall
as output expands. Similarly,
decreasing returns to scale imply that
the average cost must rise with output.
Finally, if returns to scale are constant,
the average cost is constant
independent of output. We can
summarise all this as follows:
Increasing returns to scale LAC
decreases with output
Constant returns to scale LAC
does not change with output
Decreasing returns to scale LAC
increases with output.
Now look at fig. 3.11. It shows a
U-shaped LAC curve. This means that,
as output is gradually increased
Fig. 3.11 The Long-Run Average and

Marginal Cost Curves
The short-run and long-run average or marginal cost curves are not unrelated however. As you will
learn in a higher course in microeconomics, the LAC curve is flatter than short-run average variable
cost curves.
PRODUCTION
AND
COSTS
starting from a small level, there are

increasing returns to scale (in the
output range 0 to q0) such that LAC
falls, then there are constant returns to
scale (at q0), and finally decreasing
returns to scale prevail at output levels
higher than q0, such that LAC increases
with output. In fig. 3.11, increasing,
constant and decreasing returns to
scale are written in short forms as
IRS, CRS and DRS respectively.
Now the question is why do IRS
occur first, followed by CRS and
DRS? Starting from a relatively smallscale operation (output), as the scale
of operation increases, a firm would
be able to reap the advantages of (a)
division of labour and (b) volume
discounts. To cite an example in case
of for mer, suppose that a fir m
has only o ne manag er, wh o s e
speciality is in marketing but who is
looking into both marketing and
manufacturing. Now, as the firm
increases its production and hires
another manager who expertise is in
manufacturing, then each manager
can specialise in their expertise
and be more efficient. This is
called division of labour, meaning
allocation of tasks according to the
specialisation of workers. 9 In case of
volume discounts, for instance, a
garment factory buys 100 tons of
yarn at a certain price. If, instead, it
9
59
plans to buy 200 tons of yarn it can

negotiate a better price.
However, as the output level goes
beyond a certain limit, difficulties in
managing an enterprise crop up.
Crowding and congestion occur
typically, which lead to decreasing
returns to scale.
In between IRS and DRS, a firm
experiences constant returns to scale.
It is shown at point q0 in fig. 3.11. More
generally, CRS may prevail over a range
of output, rather than at a single level
of output. In this case, the LAC will have
a flat portion in the middle.
A couple of remarks are in order:
First, given that initially increasing
returns, then constant returns and
finally decreasing returns to scale occur
as output increases, the long run
average cost is minimised where
constant returns to scale prevail, such
as at point q0. In some sense, this is the
level at which production is most
efficient.
Second, the U-shape of the LAC
curve implies the U-shape of the LMC
curve. This is different in nature from
the short run, where the U-shape of the
marginal cost curve implies the U-shape
of the average cost curve.
The concepts developed in this
chapter will be used very much in the
following chapters.
The same applies to other kinds of workers and to machinery and land. For instance, at a small scale of
operation, the firm may have only one room, which is used as a storage as well as office space for its
employees. Storing merchandise and taking them out generate traffic, which would adversely affect the
productivity of other employees. If, instead, the firm acquires an additional room, one of them can be
used as storage only and as a result the productivity of employees will improve.
60
SUMMARY
l
l
l
l
l
l
l
l
l
l
l
l
l
l
l
l
l
l
TPP is equal to the sum of MPPs.

There are generally three stages of production. In the initial stage, the
MPP increases with input employment, then it diminishes but remains
positive and finally it becomes negative.
A profit-maximising firm will never employ an input at such a level that
its MPP is negative.
The MPP and APP curves are generally inverse U-shaped.
The law of diminishing returns explains why the MPP curve is inverse Ushaped. In turn, the inverse U-shape of the MPP curve implies a similar
shape of the APP curve.
In the short run, there are fixed costs and variable costs.
In the long run, there are only variable costs.
The AFC curve is downward sloping.
The MC, AVC and ATC curves are generally U-shaped.
The sum of MCs equals the TVC.
The area under the MC curve is equal to the TVC.
The law of diminishing returns explains why the MC curve is U-shaped.
In turn, the shape of the MC curve implies the similar shape of the AVC
and ATC curves.
The MC curve cuts the AVC curve and the ATC curve at their minimum
points.
The long run marginal cost (LMC) curve and the long run average cost
(LAC) curve are generally U-shaped.
The LMC curve cuts the LAC curve at the latters minimum point.
The U-shape of the LAC curve follows from a firm experiencing increasing
returns to scale initially, followed by constant returns to scale and then
by decreasing returns to scale.
The U-shape of the LAC curve implies the U-shape of the LMC curve.
In the long run, the sources of increasing returns to scale lie in the division
of labour and volume discounts.
PRODUCTION
AND
COSTS
EXERCISES
Section I
3.1
3.2
3.3
3.4
3.5
3.6
3.7
3.8
3.9
3.10
3.11
3.12
3.13
3.14
3.15
3.16
3.17
3.18
3.19
3.20
3.21
3.22
3.23
3.24
What is a production function?

List any three inputs used in production.
What is meant by total physical product?
What is meant by average physical product?
What is meant by marginal physical product?
How is total physical product derived from the marginal physical
product schedule?
What will you say about the marginal physical product of a
factor when total physical product is falling?
What is the general shape of the MPP curve?
What is the general shape of the APP curve?
What do returns to scale refer to?
Give the meaning of increasing returns to scale.
Give the meaning of constant returns to scale.
Give the meaning of decreasing returns to scale.
Classify the following into fixed cost and variable cost.
(a) Rent for a shed.
(b) Minimum telephone bill.
(c) Cost of raw materials.
(d) Wages to permanent staff.
(e) Interest on capital.
(f) Payment for transportation of goods.
(g) Telephone charges beyond the minimum.
(h) Daily wages.
How does total fixed cost change when output changes?
How is total variable cost derived from a marginal cost schedule?
How can one obtain total variable cost from a marginal cost
curve?
What is the general shape of the AFC curve?
What is the general shape of the MC curve?
What is the general shape of the AC curve?
What will happen to ATC when MC > ATC?
What does division of labour mean?
What are volume discounts?
Name two factors behind increasing returns to scale in the long
run.
61
62
Section II
3.25
What is meant by the law of variable proportions?
3.26
Calculate the APPs and the MPPs of a factor from the following
table on its TPP schedule.
3.27
3.28
Level of Factor Employment
TPP
12
20
28
35
40
42
The following table gives the MPP of a factor. It is also known

that the TPP at zero level of employment is zero. Determine its
TPP and APP schedules.
MPP
20
22
18
16
14
The following table gives the APP of a factor. It is also known

that the TPP at zero level of employment is zero. Determine its
TPP and MPP schedules.
PRODUCTION
3.29
3.30
3.31
3.32
3.33
3.34
3.35
3.36
AND
COSTS
63
APP
50
48
45
42
39
6
35
Explain the law of diminishing marginal returns. In other words,
why does the marginal product of an input decline with further
employment of it?
How does the total physical product change with the change in
the marginal physical product of an input?
What is meant by the law of diminishing returns?
Distinguish between fixed and variable costs.
With the help of a suitable diagram, explain the relationship
between TC, TFC and TVC.
Do ATC and AVC curves intersect? Give reasons.
Why is the MC curve in the short run U-shaped?
A firm is producing 20 units. At this level of output, the ATC
and AVC are respectively equal to Rs. 40 and Rs. 37. Find out
the total fixed cost of this firm.
Section III
3.37
A firms total cost schedule is given in the following table.

Output (in units)
Total Cost In (Rs.)
40
120
170
180
210
260
340
440
550
64
(a)
(b)
3.38
3.39
What is the total fixed cost of this firm?

Derive the AFC, AVC, ATC and MC schedules.
Complete the following table if the AFC at 1 unit of production
is Rs. 60.
Output
TC
90
105
115
120
135
160
200
260
TVC
TFC
AVC
AFC
ATC
MC
A firms fixed cost is Rs. 2,000. Compute the TVC, AVC, TC and ATC
from the following table.
Output (in units)
Marginal Cost (in Rs.)
2,000
1,500
1,200
1,500
2,000
2,700
3,500
PRODUCTION
3.40
AND
COSTS
65
Suppose that a firms total fixed cost is Rs. 100, and the marginal
cost schedule of a firm is the following.
Output (in units)
Marginal Cost (in Rs.)
10
20
30
40
50
60
70
(a)
(b)
Is the MC curve U-shaped?

Derive the AVC schedule. Will the AVC curve be U-shaped?
Discuss why or why not.
3.41
Explain the relationship between ATC, AVC and MC with a

suitable illustration.
3.42
Tables A and B below outline two production technologies or

production functions. There are two factors: unskilled labour
and skilled labour. Show that the production function given in
Table A satisfies increasing returns to scale and that in Table B
satisfies decreasing returns to scale.
Table A
Unskilled Labour
(in hours)
Skilled Labour
(in hours)
Output
(in units)
10
12
14
66
Table B
3.43
Unskilled Labour
(in hours)
Skilled Labour
(in hours)
Output
(in units)
10
12
14
Increasing and decreasing returns to scale respectively imply

downward and upward sloping portion of the long run average
cost curve. Defend or refute.
REVENUES, PRODUCER'S EQUILIBRIUM
CHAPTER
AND THE
SUPPLY CURVE
67
REVENUES, PRODUCERS EQUILIBRIUM

AND THE SUPPLY CURVE
4.1 Total Revenues

4.2 Producer's Equilibrium:
The Basis of the Supply
Curve
4.3 Change in Quantity

Supplied Versus Change
in Supply
4.4 Determinants of Supply

Curves
4.5
Market Supply Curve
4.6 Time Horizon
4.7 Price Elasticity of Supply
Besides the demand forces, the supply forces

constitute the other crucial component of
market mechanism. It is the producers who
supply goods and services to the market. In
the last chapter we studied concepts
associated with production and cost, which
are relevant for producers. But we did not
learn about their choice behaviour i.e. which
level of output they should produce so as to
maximise their profits. In this chapter we
develop the revenue concepts, and, together
with the cost concepts, we study profit
maximisation. This, in turn, forms the basis
of what is called the supply curve.
Comparable to the demand curve, the supply
curve shows different quantities produced
and sold at different prices.
In the last chapter, we saw that profits are
equal to the difference between total revenues
and total costs. We also discussed how total
costs change with output. In this chapter, we
first analyse how total revenues, defined as
price output, change with output. This sets
the stage for analysing profit maximisation or
what is called producers equilibrium. It is
an equilibrium notion in the sense that if the
firm selects the level of output at which
profit is maximised, it would like to stay or
rest at that level of output; there is
68
no incentive for it to increase or

decrease output from that level.
4.1 TOTAL REVENUES
Unlike costs, the effect of a change in
output on the total revenue of a firm
depends on the market structure,
which refers to the number of firms
operating in an industry, the nature of
competition between them and the
nature of the product. In this chapter,
we will consider only one kind of market
structure, namely, perfect competition,
which is of central importance in
economic analysis. Other types of
market structure will be studied in
Chapter 6.
4.1.1 Perfect Competition
The following six characteristics define
perfect competition or a perfectly
competitive market.
(A) There are a large number of buyers
and sellers (producers).
(B) Firms sell a very homogeneous (i.e.
identical) product or service.
(C) There is free entry and exit.
(D) Perfect knowledge.
(E) Uniform price.
(F) No transport and selling costs.
It is hard to find markets, which
exactly fit the definition of perfect
competition. But the markets for goods
and services like wheat, a standard hair
1
cut or a leather football can be thought

of as examples of industries, which are
very close to perfectly competitive
markets. Because, there are typically
many producers of these items. Each
of these is a standardised item, i.e.,
naturally homogeneous. Moreover, it is
relatively easy to enter or get out of these
businesses.1
The implication of the product being
homogeneous or identical is that all
firms have to charge the same price
for the product. That is because if one
producer happens to charge a price
higher than some other, no one will buy
from the former. Why would anyone pay
more for exactly the same item? Hence,
all producers who operate in the market
must charge the same price. Product
homogeneity and the existence of a
large number of firms together imply
that each firm is very small compared
to the whole market and no single firm
can influence the market price. That is,
each firm is a price taker in perfect
competition.2 An example may help to
better understand the price taking
behaviour.
Think of a product like jalebi (a
sweet). If you operate a halwai
(sweetmeat) shop in a big town in which
there are many such halwai shops,
You can of course argue that there may be some differences between wheat produced in Punjab and
wheat produced in Australia. But, for most practical purposes, the differences are negligible. Similarly,
a standard haircut may differ slightly from one barber to another. But, again, it is essentially the same
everywhere. The chosen examples are different from, say, the market for TVs, which are differentiated.
There are black and white TVs as well as colour TVs. Even in the category of colour TVs, there are 19"
TVs and 29" TVs. TVs differ not just in quality but also in style and design.
This does not mean that the market price itself cannot change. How it may change will be studied in
Chapter 5.
AND THE
SUPPLY CURVE
and, the market price of jalebi per kg is

Rs. 70, you will charge Rs. 70 too.
Obviously, you will not charge more than
Rs. 70 (and lose a lot of, possibly, all
customers). There is also no reason for
you to sell at any price less, because
being small compared to the market,
you can sell as many jalebi as you like
at the going price in the market. Thus
you will be a price taker.
4.1.2 Total Revenue Curve and
Price Line
Once you understand that each firm
is a price taker and can sell as many
units as it wishes at the market price,
it is quite simple to relate total revenue
(TR) to output.3 For example, if you
sell five kilograms of jalebi, the TR is
Rs. 70 5 = Rs. 350. If you sell six, it is
Table 4.1 Total Revenue Schedule
Output In Kg.
TR (Rs.)
0
1
0
70
140
210
280
350
420
490
560
*Market price jalebi = Rs. 70/kg
69
Rs. 420 and so on. Table 4.1 reports

the total revenue schedule for this
example.
4.1.3 Total Revenue Curve and
Price Line
If we graph the total revenue schedule,
measuring output along the x-axis and
total revenue along the y-axis, we obtain
the total revenue curve. This is depicted
in fig. 4.1(a). At zero output, TR is
obviously zero. Hence the TR curve
must pass through the origin.
Moreover, it is a straight line. This is
because the market price is
independent of how much quantity is
sold by one firm. Turn to fig. 4.1(b)
now. The y-axis measures price, not
total revenues. Since the market price
is given or exogenous to the firm, we
obtain a horizontal line. This is called
the price line. It is also called the
demand curve facing a competitive
firm in the sense that, from a firms
perspective, it is able to sell to the
consumers any amount it wishes at
the same price. (The price elasticity of
this demand curve is infinite.)
There is a relationship between the
price line and the total revenue. That
is, the total revenue is equal to the area
under the price line. This is seen in
fig. 4.2, in which AB is a hypothetical
price line. Suppose that the firm is
producing the amount q0. Then, TR =
price quantity = OA Oq0 = OADqo,
which is the area under the price line.
The feature (C) of perfect competition, namely, free entry and exit, does not have any direct bearing on
how TR changes with respect to output. Its implication will be studied in Chapter 6.
70
(a)
(b)
Fig. 4.1 Total Revenue Curve and the
Price Line corresponding to
Table 4.1
Fig. 4.2
4
5
Price Line and Total Revenues
4.1.4 Average
Revenue
and
Marginal Revenue
These are two more revenue concepts.
Average Revenue (AR) is defined as
revenue per unit of output. It is equal
to TR/output. Note that, since TR =
price output, AR is always equal to
price.
Marginal revenue is defined as the
increase in total revenue when one
extra unit is sold, i.e., it is the
revenue obtained from one extra or
last unit sold.4 Since a competitive
firm is a price taker, if it sells one
extra unit, the extra r evenue
generated will be equal to whatever
the price is. Thus, for a competitive
firm, MR = price.5
However, the terms of AR and MR
will not be used much in this chapter.
But they will be in Chapter 6. Here they
are introduced for the sake of
completeness.
4.2 PRODUCERS EQUILIBRIUM:
THE BASIS OF THE SUPPLY
CURVE
We are now ready to study producers
equilibrium. The question is at what
level of output will a firms profit be
maximised? Unlike the numerical
method that was used in Chapter 2 to
study consumers equilibrium, we use
a graphical method to answer this
question. In order to do so, we need two
results from our study of costs and
revenues:
This is similar to the concept of marginal utility or marginal cost.

This is not true for a firm, which is not perfectly competitive.
AND THE
SUPPLY CURVE
1. The total variable cost is equal to

the area under the marginal cost
curve.
2. The total revenue is equal to the
area under the price line.
4.2.1 The
Profit-Maximising
Condition
Turn now to fig. 4.3. Suppose that a
competitive firm faces the market price
P0, that is, P0A" is the price line. Its
marginal cost curve is denoted by MC.
At which level of output is the firms
profit maximised? The answer is q0. In
other words, we are saying that, in
general, a competitive firms profit is
maximised at the point where the price
line intersects the MC curve, i.e., where
(A)
P = MC,
with P denoting the market price. This
is the profit maximising condition or the
condition for producers equilibrium.6
Why is profit maximised where the
price line intersects the MC curve?
Define gross profit equal to TR TVC.
By definition, this is equal to profit plus
TFC. However, since TFC is constant,
profit is maximised where gross profit
is maximised and vice versa. We now
argue that, at the market price P0, the
gross profit is maximised at the output
q0, where the price line P0 intersects the
MC curve.
We have TR = the area under the
price line = 0P0Aq0, and TVC = the area
under the MC curve = 0DAq0 . Thus
gross profit = 0P0Aq0 0DAq0 = DP0A.
Now consider any output less than q0,
6
71
say q'. By similar calculation, the gross

profit = DP0A'B. Notice that this is less
than DP0A. Look at next, a level of
output greater than q0, say q". The total
revenue is equal to 0P0A"q" and the total
variable cost is equal to 0DCq"; thus
gross profit = 0P 0 A"q" 0DCq" =
DP0A ACA". This is also less than
DP0A. Hence, at any level of output
either less or greater than q0, the gross
profit is less. This proves that gross
profits, and, hence profits, are
maximised at q0, where P = MC.
Fig. 4.3 Profit Maximisation
4.2.2 Rationale Behind the

Condition, P = MC
In Chapter 2 we saw that diminishing
marginal utility is the key behind the
consumers equilibrium condition of
marginal utility is equal to price. In a
parallel way, the key reason behind
the producers equilibrium condition,
P = MC, is that marginal cost be
increasing with output.
To see this, suppose that, starting
from the level of output at which P =MC,
Observe the similarity of this condition with the condition for consumers equilibrium in Chapter 2,
which stated that marginal utility be equal to price.
72
the firm decides to produce one unit

more. Given that MC is increasing in
output, P will be now less than MC.
But P and MC are respectively equal
to extra revenues earned and extra
costs incurred. Hence, extra revenues
will be less than the extra costs,
implying that the profits will be less.
Similarly, suppose that the firm
decides to produce one unit less than
where P = MC. In this case the
revenues sacrificed (equal to P) are
greater than savings in costs (equal to
MC). Hence, profits will also be less.
In summary then, increasing or
decreasing output from where P = MC
results in less profits. Thus, profit is
maximised where P = MC, as long as
MC is increasing in output.
The above discussion implies that,
if at any given market price there is a
level of output at which P = MC holds
but MC is decreasing, it cannot be the

profit-maximising level of output. Such
a possibility is shown in fig. 4.4. At
price P1, the price line cuts the MC
curve at two points, q1a and q1b, but,
unlike at q 1b, at q 1a, MC decreases.
Therefore, the profit-maximising
output is q1b not q1a .7
The preceding analysis gives rise
to an important conclusion: a
competitive firm chooses an output
only on the rising portion of the MC
curve.
4.2.3
A More General ProfitMaximising Condition
Recall the definition of MR, the

marginal revenue, and that P = MR for
a competitive firm. Thus we can write
(A) as MR = MC. That is, marginal
revenue is equal to marginal cost.
Indeed, this is a very general condition
of profit-maximisation something
that holds irrespective of the market
structure.
Having noted this, we however return
to P = MC as our profit-maximising
condition for a competitive firm.
4.2.4 Law of Supply and the Supply
Curve
Fig. 4.4
Profit Maximising Outputs at

Different Prices
The law of supply states that, other

things remaining unchanged, an
increase in the price of a product leads
to an increase in the quantity supplied
of it. It is because, higher the price, the
more a producer wants to supply.
Suppose the firm is producing at q1a. If it increases output by one unit, the extra revenue generated is
P1 and the extra cost incurred is equal to MC. But since MC is decreasing, P1 > MC, and thus profit is
higher. You can similarly argue that profit is less also if output is reduced by one unit from q1a. Hence,
profit is not maximised at q1a.
AND THE
SUPPLY CURVE
Other things refer to other

determinants of supply, which will be
discussed later.
This law, stated in a tabular form,
gives rise to the supply schedule, and,
the graph of a supply schedule gives
the supply curve. Table 4.2 lists a
supply schedule. Figure 4.5 graphs the
corresponding supply curve.
What is the basis of the law of
supply or the supply curve? Refer back
to fig. 4.4. We see that, at price P1, the
firm produces the amount q1b, at price
P2, it produces q2; and so on. Hence all
price-output combinations are simply

the points on the rising part of the MC
curve. We can think of the output as
the amount supplied to the market
(assuming implicitly that the firm
does not store anything beyond one
period). Hence it follows that the rising
portion of the MC curve is the supply
curve itself ! 8
4.3
CHANGE
IN
QUANTITY
SUPPLIED VERSUS CHANGE IN
SUPPLY
Price (Rs.)
Quantity Supplied
10
15
16
20
28
The difference between these two terms

is similar to the difference between a
change in quantity demanded and a
change in demand. A change in
quantity supplied refers to a movement
along a given supply curve because of
a price change, whereas a change in
supply means a shift of the supply
curve due to a change in other factors.
It is now the time to discuss these
factors.
25
43
4.4
Table 4.2 A Supply Schedule
Fig. 4.5 The Supply Curve for the Supply

Schedule in Table 4.2
73
DETERMINANTS
SUPPLY CURVE
OF
THE
Since the supply curve is a part of the

marginal cost curve, the factors that
shift the marginal cost curve are the
determinants of supply or the supply
curve. Generally, there are two such
factors, technological changes and
changes in factor or input prices.
Besides, in India particularly, on
many industrial goods, there are taxes
that are based on the total production
Strictly speaking, the supply curve is only a portion of the rising part of the MC curve. The reason for
this will be covered in a higher course in micro economics.
74
cost of output of a firm. These are called

excise taxes or excise duties. As we
will see, a change in the rate of excise
duty will also shift the supply curve.
There is still another factor that our
simple profit-maximising analysis does
not capture, namely, changes in the
prices of related goods.
In what follows, we consider these
determinants of supply. 9
4.4.1
Technological Changes
Science and research laboratories

around the world as well as the
business firms themselves look for new
technology or methods that reduce
costs of production. Consider for
instance the printing business. In old
days, bringing out a book in print was
a fairly complex process.10 Now a days,
with computers, word processing,
spread sheet and presentation
packages, all tasks except for printing
are done in a computer. Changes are
nearly costless to include. Using
printers to print is also an easy and
fairly inexpensive job. The average and
marginal costs facing a commercial
publisher for any given number of
9
10
11
12
printed pages are much less today than

they were prior to 1980s. This is an
example of cost-saving technological
change. In the real world, there are
many such examples.11
Such a technological advance lowers
marginal cost at any given level of
output. Table 4.3 illustrates this.
Column (2) lists an old marginal cost
schedule. Column (3) lists the new one
after the technological change.12 Notice
that each entry in Column (3) is smaller
than the corresponding entry in
Column (2), meaning that the marginal
cost has decreased for any given level of
output. The two marginal cost schedules
are plotted in fig. 4.6. As we can see, the
new MC curve lies below or to the right of
the old one. Since the MC curve is
essentially the supply curve, we have the
result that a technological progress shifts
the supply curve to the right.
4.4.2 Input Price Changes
Changes in raw material prices, wages
to workers etc. can also affect the
marginal cost curve and the supply
curve. Suppose you own a haircut
There are chance factors like weather changes or health of workers, which can also shift the marginal
cost curve. But we ignore them here. The supply curve is also influenced sometimes by price speculations.
In times of disasters like earthquake, war, famine and cyclones, prices of essential goods typically rise.
Some private producers take advantage of this situation by hoarding, that is, withholding supply of
their product to the market, expecting to sell later at very high prices. We ignore these factors in this
chapter.
Once manuscripts of books were prepared by authors in long hand, the alphabets in the manuscripts
used to be set in a frame and the frame would be mounted on a letter-press machine. The pictures and
diagrams were etched on metal plates. The whole plate had to be changed if changes were to be made
in the pictures or diagrams. The metal plate and the frame were mechanically inked and pressed on to
paper to produce a page of the book.
There is another kind of technological progress that we do not consider here, namely, development of
new products.
For simplicity, in both cases, the marginal cost always increases with output.
AND THE
SUPPLY CURVE
Table 4.3 A Decrease in Marginal

Costs due to Technological
Change
Output
Old MC
(Rs.)
New MC
(Rs.)
12
14
17
13
22
17
75
of an increase in input prices is shown

in fig. 4.7.
Fig. 4.7 Increase in Input Prices and the

Shift of the Supply Curve
4.4.3 Changes in the Excise Tax

Rate
Fig. 4.6 Technological Progress and Shift

of the Supply Curve
saloon, employ 10 barbers and service

120 haircut jobs a day now. The hourly
market wage of barbers increases for
some reason. This will increase the
cost of the haircut service that you
provide and shift your marginal cost
curve up or to the left. As a result, you
will employ fewer barbers and service
less number of haircuts.
In general then, an increase (a
decrease) in an input price shifts the
supply curve to the left (right). The case
In India, producers of various

industries in the manufacturing sector
pay excise taxes. As said earlier, these
are taxes levied on the total production
cost of a firm. Hence they add to the
total variable cost. Therefore, a change
in the rate of this tax affects the overall
marginal cost.
Suppose the rate of excise duty on
a particular product increases. For any
given level of output, this would
increase the marginal cost and hence
shift the MC curve and the supply
curve to the left.
Thus, an increase (a decrease) in
the excise tax shifts the supply curve
to the left (right).
4.4.4 Change in the Prices of
Related Products
Many producers, with their given
amount of resources, manufacture or
76
grow more than one item. Consider a

farmer who has a given amount of land,
which he can use to produce wheat or
corn (or both). If the market price of
wheat increases, he will grow less corn
even when the price of corn, the
technology of producing corn and input
prices (e.g. the price of corn seeds)
remain the same. It is because growing
corn is less profitable now, compared
to growing wheat. This will shift the
supply curve of corn to the left.
Thus an increase (a decrease) in
the price of a substitute good in
production shifts the supply curve of
a good to the left (right).
4.5 MARKET SUPPLY CURVE
This is parallel to the market demand
curve. It is derived as the horizontal
summation of individual supply curves.
In Chapter 2 the market demand
schedule was obtained by numerically
adding up individual demand
schedules. Here, the market supply
curve is derived in an equivalent,
geometric way (so that you get to know
both ways).
Fig. 4.8
Assume that there are two firms in

an industry, A and B. In fig. 4.8 the
curves SA, SB and SA+B respectively
denote As supply curve, Bs supply
curve and the market supply curve. For
example, at price P1 the producer A
supplies A1 units and the producer B
supplies B1 units. The total quantity
supplied to the market is then A1 + B1,
shown along the SA+B curve against this
price. Similarly at P2, the total quantity
supplied is A2 + B2, where A2 and B2 are
quantities supplied by producers
(firms) A and B respectively. All other
points on the market supply curve are
derived in the same manner.
Note that a market supply curve is
derived on the assumption of a given
number of firms (100, 200 or whatever
it may be). Hence, apart from any factor,
like a technological change or a change
in any input price, that shifts the
individual supply curve and thereby
the market supply curve, the latter
also shifts when the number of
firms
changes.
An
increase
(a decrease) in the number of firms
shifts the market supply curve to the
right (left).
Individual Supply Curves and the Market Supply Curve
AND THE
SUPPLY CURVE
When there is an increase (a

decrease) in the number of firms, we say
that there is more (less) competition in
the market. Thus, we can also say that
more (less) competition shifts the
market supply curve to the right (left).13
4.6 TIME HORIZON
An element of time lies behind the
supply curve being upward sloping.
Suppose that you manufacture
chewing gum. The market price that
has been prevailing for a long time is
one rupee a piece. At this price, you
were producing 1 lakh chewing gums
per month. Now suppose the price
increases to two rupees a piece. This is
good news for you. As a rational
producer, you would want to produce
more by hiring more workers, more
chemical engineers, more equipment
etc. This will mean that your supply
curve is upward sloping.
However, it takes time to hire people,
get new machinery etc. Within a very
short period, you cannot make these
changes. Your production level in a very
short period of time is given, irrespective
of whether the price may have changed
to Rs. 2, Rs. 3 or Rs. 1.50. The resulting
supply curve will be a vertical line, as
shown in fig. 4.9. Such a short period
13
77
is called the market period in

economics. By definition, it is that short
a period within which firms cannot
adjust their output to any change in
price. As a result, the supply curve of a
firm or the whole industry is vertical.
In a longer run i.e. in the short
run or long run the supply curve will
be upward sloping, as drawn earlier,
because inputs can be changed.
Fig. 4.9 Supply Curve in the Market Period
4.7 PRICE ELASTICITY OF SUPPLY

4.7.1 Definition and the Percentage
Method of Measurement
Parallel to price elasticity of demand,
the price elasticity of supply quantifies
the responsiveness of quantity supplied
to changes in price. It is defined as
(B) Price elasticity of supply = es
As you know, India has been following a path of economic liberalisation, especially since the 1990s.
Many foreign firms that couldnt earlier enter the Indian market in different sectors can and do so now.
Thus liberalisation brings forth more competition. The Indian automobile market is a prime example of
this.
Until the seventies, in the passenger car market there were only two companies that were allowed to
operate: Hindustan motors (with Ambassador) and Fiat (with Premier Padmini). In the 1980s came
Maruti, which is owned jointly by the Indian government and Suzuki Motor Corporation of Japan. In the
1990s, many foreign companies started to produce and sell such as Daewoo of South Korea (Cielo),
Hyundai of South Korea (Santro), Honda of Japan (Honda City) etc. Even Telco, an Indian Company,
which earlier produced only trucks and buses, entered into the production of small sized cars (Indica).
78
% change in the quantity supplied

% change in the price
On a given supply curve, let P0 and
S 0 denote the original price and
quantity. If the price rises to P1 and
quantity supplied increases to S1, the
% changes in price and quantity
supplied are respectively
[(P1 P0 )/P0] 100 and [(S1 S0 )/S0]
100. Hence
(S S 0 ) / S 0 S / S 0
=
(C ) es = 1
,
(P1 P0 ) / P0
P / P0
where denotes the change.
If the supply curve is vertical, then
the price elasticity of supply is,
obviously, zero. Otherwise, given that
the supply curve is positively sloped,
the price elasticity is positive.
As a numerical example, suppose
that you manufacture one type of ballpoint pens. When they were selling at
the price Rs. 8, you produced and sold
5,000 pens a month. Now its market
price has increased to Rs. 10 and you
are producing and selling 8,000 pens
a month. In this example, P0 = Rs. 8,
(a)
Fig. 4.10
S0 = 5,000, P1 = Rs. 10 and S1 = 8,000.

Thus,
[(P
1
P ) / P ] 100
0
0
[(10 8) / 8] 100
25,
and
[(S1 S 0 ) / S 0 ] 100 =
[(8000 5000)]/ 5000] 100 = 60.
Hence, eS 60 / 25 2.4.
Just as in case of price elasticity of
demand, (a) the price elasticity of supply
is independent of units, and (b), if two
supply curves intersect, the flatter one
has higher price elasticity at the point of
intersection. The reasons are exactly
parallel what they were in case of price
elasticity of demand.
4.7.2
The Geometric Method
Also similar to point elasticity of demand,

for very small price changes, the price
elasticity of supply can be measured by a
convenient geometric formula.
Refer to fig. 4.10. It shows three
straight line supply curves. Panel (a)
illustrates one, in which the supply
curve, extended towards the x-axis,
intersects the x-axis in its negative
(b)
(c)
Price Elasticity associated with Straight Line Supply Curves
AND THE
SUPPLY CURVE
range at point B. In fig. 4.10(b), the

supply curve intersects the x-axis in
its positive range. Finally, in fig. 4.10(c),
the point of intersection is the origin;
that is, the straight line supply curve
passes through the origin. In all panels,
P0 is the original price, 0C is the
quantity supplied and A is the point
on the supply curve.
It turns out that the point elasticity
is equal to the horizontal segment BC
divided by the quantity supplied 0C,
that is, BC/0C. 14 (Ignore for the moment
fig. 4.1.(c) in which there is no point B.)
79
Thus, along the supply curve in

panel (a), the price elasticity is greater
than one (as BC > 0C). By the same
argument, along the supply curve
in panel (b), it is less than one
(as BC < 0C).
Finally, in panel (C), you can say
that the point B is same as the origin.
Thus BC = 0C implying e s=1. That
is, any straight line supply curve
passing through the origin,
irrespective of how steep or flat it is,
implies price elasticity of supply
equal to one.
CLIP 4-1
Does computerisation reduce employment?
This is a sensitive issue for a populous country like India. The traditional thinking
is that computerisation or for that matter, any technical improvement that is
labour-saving is or must be bad for employment. If you replace a person with a
machine, how could it not reduce employment? This is, however, a narrow point of
view, having two major flaws. First, it has a very short run perspective, and second,
it presumes that those who are replaced by computers or machines do not have or
are incapable of developing any other skills and hence must remain unemployed
for a long time.
Yes, at the time when a machine is replacing a person or many persons, it has a
negative effect on employment. But this is hardly the end of the story. A firm is doing
it in order to save costs. As the total variable cost curve shifts down, so does the
marginal cost curve. This means that the supply curve will shift out and more will be
produced in the new equilibrium. From the whole economys perspective, the production
possibility curve (see Chapter 1) shifts out. Higher output would require more
employment of workers, both skilled and unskilled. Also, computerisation by itself
creates demand for new types of jobs. Hence there is little reason to believe that
computerisation will reduce employment in the long run. On the other hand, it leads
to a greater productivity of workers and higher wages.
The negative effects of computerisation are present only in the short run. A
traditional typist who is replaced by a computer can learn word processing and
possibly land a more paying job. Of course, computerisation or mechanisation
may, for example, take away the job of artisans, who with their own bare hands,
make beautiful handicrafts. On the other hand, expansion of the small-scale
14
The proof of this is beyond our scope.
80
industries due to computerisation will lead to more employment. In the worst case,
one type of job is replaced by other type of job: the workers who lose their jobs and
cannot change their skills may not get their jobs back, but other category of workers
will now find jobs.
In summary, there may be employment costs of computerisation, but only in the
short run. On the other hand, there are major long-run benefits.
SUMMARY
l
The total revenue curve facing a competitive firm is a straight line passing
through the origin.
The price line facing a competitive firm is horizontal because this firm is
a price taker.
The price line is also interpreted as the demand curve facing a competitive
firm.
A perfectly competitive firm maximises profits, i.e., attains producers

equilibrium, when price is equal to the marginal cost.
In general, a firms profit maximising condition is that marginal revenue

is equal to marginal cost.
The profit-maximising condition, price is equal to marginal cost, forms

the basis of the supply curve.
Increasing marginal cost explains the law of supply or why the supply
curve is upward sloping.
A firms supply curve consists of the rising portion of its marginal cost
curve.
A cost saving technological progress shifts the marginal cost curve down
and hence shifts the supply curve to the right.
An increase in input prices shifts the marginal cost curve up and hence
shifts the supply curve to the left.
An increase in the rate of the excise duty shifts the supply curve to the
left.
An increase in the price of a substitute good in production shifts the

supply curve of the product in question to the left.
Market supply curve is obtained by horizontally summing up the
individual supply curves.

l
l
l
l
l
l
AND THE
SUPPLY CURVE
An increase in the number of firms shifts the market supply curve to the
right.
During the market period, the individual and the industry supply curves
are vertical.
Price elasticity of supply measures the responsiveness of quantity
supplied to a change in its own price.
A straight line supply curve which intersects the x-axis in its negative
range implies price elasticity of supply greater than one.
A straight line supply curve which intersects the x-axis in its positive
range implies price elasticity of supply less than one.
A straight line supply curve passing through the origin implies price
elasticity equal to one, irrespective how steep or flat it is.
EXERCISES
Section I
4.1
4.2
4.3
4.4
4.5
4.6
4.7
4.8
4.9
4.10
4.11
4.12
4.13
What is meant by producers equilibrium?

What is the relationship between total revenue, price and
quantity sold?
What is the relationship between price and marginal revenue
for a competitive firm?
What is the condition of producers equilibrium for a competitive
firm?
What is the condition of profit maximisation for a competitive
firm?
What is the general profit maximising condition of a firm?
What is meant by the Law of Supply?
What is meant by a change in the quantity supplied?
What is meant by a change in supply?
Due to improvement of technology, the marginal costs of
production of televisions have gone down. How will it affect
the supply curve of television?
What effect does a cost saving technical progress have on the
supply curve?
What effect does an increase in input price have on the supply
curve?
What effect does an increase in excise tax rate have on the supply
curve of the product?
81
82
4.14
4.15
4.16
4.17
4.18
4.19
If a farmer grows rice and wheat, how will an increase in the

price of wheat affect the supply curve of rice?
What is meant by market period?
How will an increase in the number of firms shift the market
supply curve?
What does price elasticity of supply measure or quantify?
If two supply curves intersect, which one does have higher price
elasticity?
What is the price elasticity associated with a straight line supply
curve passing through the origin?
Section II
4.20
4.21
4.22
4.23
4.24
4.25
4.26
Why is the total revenue curve facing a competitive firm a straight

line passing through the origin?
What factors determine the market structure?
What are the features of perfect competition?
What is meant by a product being perfectly homogeneous? What
is its implication for the price charged by producers in the
market?
Briefly explain why a perfectly competitive firm is price-taker in
the market.
A perfectly competitive firm faces market price equal to Rs. 15.
(a) Derive its total revenue schedule for the range of output
from 0 to 10 units.
(b) Suppose the market price increases to Rs. 17. Will the new
TR curve be flatter or steeper?
Complete the following table when each unit of a commodity
can be sold at Rs. 5.
Quantity Sold
1
2
3
4
5
6
7
TR
MR
AR
4.27
4.28
4.29
4.30
4.31
4.32
4.33
4.34
4.35
4.36
SUPPLY CURVE
AND THE
83
A firms TR schedule is given in the following table. What is the

product price facing the firm?
Output
TR (Rs.)
14
21
28
35
Why is AR always equal to MR for a competitive firm?

Name three factors that can shift a supply curve.
Give two examples where technological progress leads to a shift
in the supply curve.
How does a change in the price of inputs affect the supply curve
of a commodity and why?
How does an increase in the rate of excise tax shift the supply
curve and why?
How does a cost saving technological progress shift the supply
curve and why?
A new technique of production reduces the marginal cost of
producing stainless steel. How will this affect the supply curve
of stainless steel utensils?
Because of cyclone in a coastal area, the sea level, covers a lot of
rice fields. This reduces the productivity of land. How will it
affect the supply curve of rice of that region?
Consider the following individual and market supply schedules.
Price
(in Rs./kg.)
Firm A
(kg.)
Firm B
(kg.)
Firm C
(kg.)
Market
(kg.)
20
45
100
37
30
50
40
55
135
44
50
154
48
60
65
84
(a)
4.37
4.38
Complete the above table on quantities of potatoes supplied

by the firms and the market.
(b) Plot the supply curve of each firm and the market supply
curve in a single diagram. What relationship do you observe
between the individual supply curves and the market
supply curve?
(c) Calculate the price elasticity of supply of Firm A when price
rises from Rs. 2 to Rs. 3.
Draw straight line supply curves with (a) unitary price elasticity
and (b) zero price elasticity.
The above diagram shows the supply curve of 3 commodities.

Rank their price elasticities.
Section III
4.39
Show that the rising portion of the marginal cost curve is the
supply curve of a competitive firm.
PRICE DETERMINATION UNDER PERFECT COMPETITION
85
U N I T- I V
FORMS
OF
MARKET
AND
DETERMINATION
PRICE
86
CHAPTER
PRICE DETERMINATION UNDER

PERFECT COMPETITION
5.1 Market Equilibrium and
Determination of Price
and Quantity
5.2 Demand and Supply

Shifts
5.3 Sources of Demand

Shifts
5.4 Sources of Supply Shifts
5.5 Anatomy of Famines

5.6 Efficiency of the Price
Mechanism and
Competitive Markets
5.7 Economic Policy by the

Government and Market
Equilibrium
The foundations underlying the demand and

supply curves were laid in Chapters 2 and 4
respectively. These curves respectively tell us
how much consumers demand and how
much producers supply at different prices.
But they do not tell us what the actual price
of the product will be (in principle) or, in other
words, what points on the demand or the
supply curve will be actually chosen in the
market place.
This issue is addressed in this chapter by
pooling together what we have learnt about
the demand and supply. It forms the core of
how the market system works in particular
how an economys central problem of what
is solved through the price mechanism. You
will see that there are not many new concepts
or definitions to be learnt. The emphasis is
on applications. A number of examples will
be provided as we proceed.
5.1
MARKET
EQUILIBRIUM
AND
DETERMINATION OF PRICE AND
QUANTITY
Consider fig. 5.1. It depicts the market

demand and supply curves of a particular
product, denoted respectively by DD and SS.
The question is: which price will prevail in
the market? Suppose that, initially, the price
in the market for that good is P1. At this

price, the consumers demand the
quantity D1 and the producers supply
the quantity Q1. Obviously, there is a
mismatch. Consumers want more
than what the producers are willing
to supply. There is excess demand,
equal to AB or Q1D1.1 Will then the
price stay at P1? No, excess demand
will create competition among the
buyers and push the price up. It will
increase, say, to P2. Excess demand is
present at this price also. Thus price
will increase further. Indeed, the price
will keep increasing as long as there
is an excess demand. This is indicated
by the upward-looking arrow. Finally
it will converge to PO, at which there is
no excess demand.
Just the opposite happens if
initially the price is P3. The quantity
demanded (D3) is less than the quantity
supplied (Q3). There is excess supply,
equal to D3 Q3 which will create
competition among the sellers and
lower the price. The price will keep
falling as long as there is an excess
supply. It is indicated by the arrow,
pointing downwards. Where will the
price finally settle? The answer is again
P0, at which there is no excess supply.
The situation of zero excess
demand and zer o excess supply
defines
market
equilibrium.
Alternatively, it is defined by the
equality between quantity demanded
and quantity supplied. In fig. 5.1, it is
shown at the point E0. The price P0 is
1
87
called the equilibrium price. Recall that

equilibrium means a position of rest.
Here, the market rests at price P0 in
the sense that there is no pressure on
price to either increase or decrease. The
equilibrium quantity exchanged
(between consumers and producers) is
equal to Q0.
This is how price and quantity are
determined in the market.
Fig. 5.1 Market Equilibrium
As a numerical example, consider

Table 5.1, which gives the demand and
supply schedules of bananas (in a
given geographical location and within
a given time period). The equilibrium
price is Rs. 21, since at this price
quantity demanded matches with
quantity supplied. The equilibrium
quantity sold/purchased is 6,000
dozens. The corresponding demand
and supply curves and market
equilibrium are shown in fig. 5.2.
The term excess demand here refers to a particular commodity or service. This is different from what
is meant by excess demand in macroeconomics.
88
Table 5.1
An Example of Demand, Supply and Equilibrium
Price of Bananas
per dozen (in Rs.)
Quantity Demanded
(in dozen)
Quantity Supplied
(in dozen)
18
10,000
1,000
19
8,000
2,000
20
7,000
4,000
21
6,000
6,000
22
5,000
7,500
23
4,500
8,500
Fig. 5.2 Market Equilibrium Corresponding to Table 5.1
It is, however, quite possible that a

situation such as in fig. 5.3 occurs: the
demand curve and the supply curve do
not intersect with each other at any
positive quantity. What does this mean?
This means that the product in
question will not be produced in the
economy. The industry is not
economically viable. The price at
2
which any positive amount can be

supplied is higher than what the
consumers are willing to pay. Put
differently, costs are too high for any
positive output to be produced.
In India and many other countries,
commercial aircraft is such an
example, i.e., it is not produced at all.
Of course, an industry, which is not
viable in one country, can be viable in
some other. For example, commercial
aircrafts are produced in America,
Russia, Britain and France.2
Fig. 5.3
A Non-Viable Industry
Computer memory chips, mother boards and copying machines are other examples. These are totally
imported, not produced at all in India.
89
Figs. 5.1 and 5.3 illustrate how the

what problem of an economy is solved
by market mechanism. Goods and
services for which fig. 5.3 applies are not
produced. Those for which fig. 5.1
applies are. Given that a good is
produced, from fig. 5.1 we also know the
quantity that will be produced and the
price that will be charged in equilibrium.
5.2 DEMAND AND SUPPLY SHIFTS
For any given product in the real world,
price and quantity exchanged change
from time to time. Some of you must
have shopped for fruits and vegetables
for your family or for yourself. The same
cauliflower, for example, costs less in
the winter than in the summer. Apples
sell for less in some seasons than
in others. A computer for a given
configuration sells in your town for,
say, Rs. 30,000. The same computer
will sell for much less, six months after.
The analysis of demand and supply
curves and the market equilibrium
provides the framework to explain such
changes. How? Through shifts in the
demand curve, the supply curve or
both. We already know in Chapters 2
and 4 how various factors cause shifts
in these curves. Changes in those
factors explain price and quantity
changes.
Without going into what causes a
shift, we first discuss how a demand
or a supply shift will affect price and
quantity.
5.2.2
Demand Shifts
Turn to fig. 5.4(a). Let the initial

demand and supply curves be DD0 and
(a)
(b)
Fig. 5.4
Demand Shifts
SS0 respectively. Accordingly, the initial

price and quantity are respectively P0
and Q0. Now let the demand curve shift
to the right, as shown by DD1. We see
immediately that the equilibrium point
shifts from E0 to E1. The new price and
quantities are P1 and Q1 respectively.
Thus both price and quantity increase.
It is important to understand the
economic process that leads to these
changes.
Starting from the initial situation
of no excess demand or supply [at E0
in fig. 5.4(a)], a rightward shift of the
demand curve moves the consumption
point from E0 along DD0 to A along DD1.
90
This creates an excess demand, equal

to Q0Q'. In turn, it causes price to
increase, and, hence the new price
settles at a higher level. While there is
a change in demand, producers
however operate on the same supply
curve. Hence, there is a change in the
quantity supplied, not a change in
supply. At a higher price they supply
more quantity. This explains why the
new quantity exchanged is greater.
Likewise, a leftward shift of the
demand curve will lower the
equilibrium price and quantity, as
shown in fig 5.4(b).
and supply curves are denoted again

as DD 0 and SS 0; E 0 is the original
equilibrium point. Suppose the supply
curve shifts to the right to SS1. The new
equilibrium point is E1. The new price
and quantity are P1 and Q1. We see that
the price decreases and the quantity
increases. Why? At the original price P0,
an increase in supply causes an excess
supply in the market. This causes the
price to fall and the new price settles
at a level that is less than the original
price. Since the demand curve remains
the same, the decrease in price leads
to a downward movement along the
demand curve. More quantity is
demanded and in equilibrium more is
produced.
The effects of a leftward shift of
the supply curve cause rise in price
and fall in quality as shown in
Fig. 5.5 (b)
5.2.4 Simultaneous Demand and
Supply Shifts
(a)
Fig. 5.5
5.2.3
(b)
Supply Shifts
Supply Shifts
Now consider supply shifts, shown in

fig. 5.5. In panel (a) the original demand
It is possible that both demand and

supply shifts occur simultaneously.
Their net impact on price and quantity
will be a combination of 1 and 2 in
Table 5.2.
For example, the demand and
supply curves both shift to the
right. Then the market price
may increase or decrease, but the
quantity exchanged will increase
unambiguously. The opposite happens
if both curves shift to the left.
Similarly, if the demand curve
shifts to the right and the supply curve
to the left, the market price will
unambiguously increase, while the
Table 5.2
91
Summary of Demand and Supply Shift Effects
1. A rightward (leftward) shift of the demand curve leads to an increase (a

decrease) in market price and an increase (a decrease) in the quantity
exchanged.
2. A rightward (leftward) shift of the supply curve leads to a decrease (an
increase) in market price and an increase (a decrease) in the quantity
exchanged.
If it is an inferior good, we know that
an increase in income shifts the demand
curve to the left. Fig. 5.4(b) then applies:
both price and quantity fall.
Example 5.1 Market for Real Estate
in Kerala.
quantity exchanged may increase or

decrease. The opposite happens if the
demand curve shifts to the left and the
supply curve to the right.
We return now to demand and
supply shifts one at a time, examine
their causes, and, by using Table 5.2,
their effects of price and quantity.
5.3 SOURCES OF DEMAND SHIFTS
Recall from Chapter 2 that the market
demand curve can shift because of
changes in income, prices of related
goods, tastes or size of the market. We
analyse each of these in turn.
A Change in Income
Example 5.2 Japan in late 1980s and

early 1990s.
Suppose that there is an increase in

aggregate income in an economy. We
know from Chapter 2 that, as long as
a product is normal, the demand curve
for it shifts to the right. Fig. 5.4(a)
applies. Both price and quantity
increase. For a decrease in income
fig. 5.4(b) applies. Both market price
and quantity fall. Therefore, for a
normal good, an increase (a decrease)
in income leads to increases (decreases)
in the price and quantity exchanged.
5.3.1
Think of the market for land, flats etc.

The 1990s saw a large increase in urban
land price and a vast increase in the
number of single-houses and apartment
buildings in Kerala, especially in towns
like Cochin, T richur, Kottayam,
Chalakudi and Chavakkad. It was not
because there was a massive
industrialisation or an unusual
population explosion in these areas.
Instead, the reason was that a lot of
Keralites from these areas moved to the
Middle East countries to work and
earned substantial income there.3 They
used that income to buy more and better
housing at home. This shifted out the
market demand curve for housing in
urban Kerala. In some places the land
price almost trippled in two years.4
In this period, as the Japanese economy

was growing strongly, various name
Air India even operated special flights from Trivandrum to the Middle East to accommodate the
increased traffic. An estimated 16 lakh Keralites were working in the Middle Eastern countries and
they brought, annually, foreign exchange worth of 700 to 1,000 crores of rupees.
This is based on Sonali Mujumdar, Highrise Hungama, Touchdown India, undated.
92
Take for instance, the market for tea.

Suppose the price of coffee rises for
some reason. From our analysis of
demand shifts in Chapter 2, we know
that, tea being a substitute of coffee,
the demand curve for tea will shift to
the right. Fig. 5.4(a) applies then. The
price of tea rises and so does the
quantity of tea exchanged. Thus, as the
price of a substitute good in
consumption rises, the price of a given
product rises and its quantity
exchanged increases.
Unlike coffee and tea, sugar
consumption is complementary to tea.
Suppose the price of tea goes up. How
does it affect the sugar market? From
Chapter 2 again, the demand curve for
it shifts to the left. Applying fig. 5.4(b),
we find that the price of sugar as well
5
Example 5.3 Prices of Coffee and Tea

in the World Market in the Late 1990s.
5.3.2 A Change in the Price of a

Related Good in Consumption
as its quantity will fall. Hence, as the

price of a complementary good
increases, the price of a given product
and its quantity exchanged both
decrease.
Brazil is a major producer in the world

coffee market. In 1994, it was hit by two
severe frosts, which damaged more than
half of its coffee trees. As a result, the
price of Brazilian coffee in the world
market shot up and it remained high in
the next few years. With a lag of two
years, the price of tea in the world market
also jumped up (while the production of
tea was still growing). This can be
interpreted as a delayed effect of an
increase in the price of coffee on demand
for tea.6
brand products became the outlet for

rising income. For example, there was
an increase in demand for Levis jeans
and Nike shoes. As a result, the prices
and quantities sold of these items in
Japan soared.5
5.3.3 A Change in Tastes

Think about the market for bitter
gourd.7 Surely it is not a very popular
vegetable in your age group. But
imagine that medical research shows
that eating 100 grams of bitter gourd
per day prevents pimples on the face.
This will definitely generate a
See William Baumol and Alan Blinder, Economics: Principles and Policy, 8th Edition, Harcourt College
Publishers, 2000, page 80. Also see JETRO (Japan External Trade Organization), The Japanese
Consumer: From Boom to Reality, 1994, http://www.jetro.go.jp/it/e/pub.
In the New York wholesale market, Brazilian coffee sold for $1.43/pound in 1994, compared to
66.58 cents in 1993, i.e. it more than doubled. It remained high for the next four years ($1.46, $1.20,
$1.67 and $1.22 in 1995, 1996, 1997 and 1998 respectively). During the same time period, the
wholesale tea prices, as quoted in the London auction market, were 84.20 cents, 83.15 cents, 74.46
cents, 80.36 cents, $1.08 and $1.08 per pound for the years 1993, 1994, 1995, 1996, 1997 and
1998. Observe that the tea price went up particularly in 1997 and 1998. However, the world production
of tea in 1997 was 2% higher than that in 1996, and, in 1998, it was 11% higher than it was in 1997.
The Data sources are the following. For coffee and tea prices, it is International Monetary Fund,
International Financial Statistics Yearbook 2000. For tea production, it is the web site of UK Tea
Council, namely, http://www.teacouncil.co.uk.
This is called karela in Hindi, kalara in Oriya and Pavakkai in Tamil.
quantity, whereas a decrease in the

population will do the opposite.
Example 5.5 Land Price Increase in
Delhi in 1980s.
Compared to 1970s, there was a
substantial increase in land price in
Delhi. It was because of large scale
migration of people from Punjab to
Delhi following disturbances in Punjab
in the mid 1980s. This can be
interpreted as an increase in market
size for land in Delhi, which pushed
up the land price in Delhi.
change in your food habits.8 Many of

you will start to eat more bitter gourd
than before. The market demand curve
will shift out. We can use fig. 5.4(a), and
deduce that price of bitter gourd as well
as the total quantity produced and
consumed of it will increase.
Likewise, a decline in liking for a
product will cause opposite changes.
Thus, a favourable (an unfavourable)
change in taste will cause product
price and quantity exchanged to
increase (decrease).
93
Example 5.4 Market for Air Travel.
8
9
10
During this period the price of houses

in this city in Canada increased
substantially from nearly 2.2 lakh
Canadian dollars, on the average, in
1990 to nearly 3.08 lakh Canadian
dollars, on the average, in 1995. This
was primarily due to the huge migration
of people from Asian countries,
especially from Hong Kong. Uncertainty
over the future of Hong Kong after the
scheduled hand-over of the city from
Britain to China in 1997 forced many
residents of Hong Kong to leave for
United States and Canada. They were,
by and large, wealthy. Most of those
who came to Canada settled in
Vancouver.9 Their demand for housing
was the main factor behind the house
price surge there during the period
1990-1995.10
5.3.4 A Change in Market Size

By now you should know immediately
how this affects price and quantity. An
increase in population would shift the
market demand curve to the right and
result in a higher price and a higher
Example 5.6 House Price Rise in

Vancouver, Canada, during 1990-1995.
Consider air travel. After the terrorist

attacks in America on September 11,
2001, many people became afraid of
flying. This can be thought of as an
adverse change in tastes due to fear of
flying, which would shift the demand
curve for air travel to the left. The price
of air tickets would fall and less number
of people would travel. These things did
happen. Shortly after that day, there
was a major decline in the ticket price
of air travel within America and a large
decrease in the number of passengers.
Many airlines had to reduce their scales
of operation drastically.
Recall that a change in taste does not only include a change in taste in ones mouth; it means a
change in demand due to reasons other than price or income changes.
Overall, migration from overseas contributed 79% to the net population growth of Vancouver.
The source of this material is David Ley and Judith Tutchener, Immigration and Metropolitan House
Prices in Canada, Research on Immigration and Integration in the Metropolis Working Paper Series,
Vancouver Centre of Excellence, March 1999.
94
5.4 SOURCES OF SUPPLY SHIFTS
5.4.2 Change in Input Prices
In Chapter 4 we learnt that

technological progress, changes in
input prices, changes in excise taxes or
changes in the prices of related goods
in production cause shifts in a firms
supply curve and hence shifts in the
market supply curve. Moreover, a
change in the number of firms shifts the
market supply curve without affecting
the individual supply curves.
From Chapter 4 we know that the

supply curve shifts to the right or left,
as an input price decreases or
increases. Therefore, in view of
figs. 5.5(a) and (b), the product price
decreases and the quantity rises or
the price increases and the quantity
falls according as an input price
decreases or increases.
5.4.1
Example 5.8 Personal Computers.
Technological Progress
It shifts the supply curve to the right.

Fig. 5.5(a) applies. Thus, technological
progress leads to a fall in price and an
increase in quantity exchanged.
11
Note carefully that Example 5.7

was about a decrease in input price
due to technological progress, whereas
in Example 5.8 the product
price decreases because of decrease
in input prices.
Example 5.9 Internet Caf Rates in
India.
This is a prime example of technological

progress. As you might know, the brain
of any micro-computer is its CPU, the
Central Processing Unit. About 1.5 square
inches in size only, the CPU is placed
inside a computer. Its speed (similar to
the speed of brain) is given in a MHz
rating.11 Over the last few decades, the
production of CPU has seen phenomenal
technological progress. As a result, we
see the price of a CPU of a given speed
going down rapidly over time. Indeed, the
technological progress is so rapid that,
after being introduced in the market, a
CPU of a given speed becomes almost
obsolete in a matter of 6 to 7 years,
sometimes less. For instance, in 2000, a
550 MHz CPU cost around Rs. 14,000. A
year later in 2001, it was selling at around
Rs. 9,000.
Example 5.7 Micro-computer CPUs.
It is a common observation now a days

that the price of a PC system (the
computer, the monitor and the printer)
of given configurations goes down
rapidly over time. It is because the
components (i.e. inputs) that go into
making a PC are becoming increasingly
cheaper. The case of CPU was discussed
in Example 5.7. Other components of
a computer system are becoming
cheaper also. A 15" colour monitor used
to cost around Rs. 8,400 in 2000. In
2001, it came down to about Rs. 7,000.
These cafes have sprawled in many

cities, big and small, all over India.
In the year 2000, in Delhi an hourly
For example, at the time of writing this book, my desk-top computer had a 550 MHz CPU in it.
rate for internet surfing was no less

than Rs. 50. In 2002, it came down
to an average Rs. 15 in many such
cafes. 12 This is because of reduction
in input prices. First, the price of
computers came down. Second, the
internet access charges to these cafes
by ISPs (Internet Service Providers)
such as VSNL (Videsh Sanchar Nigam
Limited), Satyam etc. went down.
Third, in connecting to the ISPs,
instead of phone lines, cable lines
could be used, which are cheaper and
through which the connection can
be kept uninterrupted for 24 hours a
day.
5.4.4 Increase in the Price of

Substitute
Goods
in
Production
It was also discussed in Chapter 4 that
an increase in the price of a substitute
good in production shifts the supply
curve of a given product to the left.
Applying fig. 5.5 we can then say that
an increase (a decrease) in the price
of a substitute good in production
leads to an increase (a decrease) in
price and a decrease (an increase) in
quantity.
5.4.5 Number of Firms
5.4.3 Change in Excise

In Chapter 4, we saw that an increase
(decrease) in the excise duty rates
shifts the supply curve to the left
(right). From fig. 5.5 then, it follows
that the price of the product will
increase (decrease) and quantity
transacted will decrease (increase),
as the excise duty rate increases
(decreases).
Example 5.10 Cosmetics
Toiletories in 2002.
and
Example 5.11 Mobile Phone Rates.
In the union budget of 2002-2003, the

special excise duty on cosmetics and
toiletories, 16% earlier, was completely
removed. As soon as it happened, major
companies like Hindustan Livers Ltd.
(HLL), Godrej and Proctor and Gamble
(P & G) reduced prices in this category
of products. For example, HLL reduced
prices across a variety of brands
including Clinic and Sunsilk shampoos,
Ponds skin creams, Ponds talc and
Lakme make-up products.
Even when the individual supply curve

does not shift, the market supply curve
can if the number of suppliers in the
market changes. We already know that
an increase in the number of firms
(which can be interpreted as greater
competition) shifts the market supply
curve to the right. A decrease in the
number of firms, i.e., less competition
does the opposite. Thus, from
figs. 5.5(a) and (b), price falls and
quantity rises or price rises and quantity
falls, as there is more or less competition
in terms of the number of firms.
12
95
This rates were found from the authors own survey.
Mobile phones came to the four major

cities of India in the mid 1990s. In
Delhi, there were initially two
companies: AirTel and Essar. The
charges for outgoing and incoming calls
were quite high, no less than Rs. 15
per minute. By the end of 2002, there
96
were four companies : Bharati's AirTel,

Hutchison's Hutch (which acquired
Essar), MTNL's Dolphin and Tata-Birla
-AT & T's Idea. The mobile phone rates
have come down drastically. Incoming
calls in some schemes are even free.
Although the mobile phone market

has only a few number of firms, not
many as in a perfectly competitive
market, it is the entry of new firms,
which is a contributing factor in the
decline of mobile phone charges.
5.4.6 Other Factors
Factors like weather, natural disasters
such as cyclone, flood etc., which are
results of Natures play, can also affect
the supply of a product. For instance,
variation in agricultural output in India
from one year to the next is dependent
partly on how good the monsoons are.
A specific example of this and its effect
on price is given below.
Example 5.12 (In)Famous Onion Price
Increase in 1998.
5.5 ANATOMY OF FAMINES: AN

APPLICATION OF THE DEMANDSUPPLY ANALYSIS
In October -November of 1998, the

onion price in India increased 6 to 10
times from its usual price. Onion being
a very common vegetable, consumed by
most households, it became a very
politically sensitive issue. The reason
behind this unprecedented onion price
rise was heavy rains and flooding in the
onion growing areas in India, which
caused a drastic decrease in supply of
onions to the market in that year.
13
In the Bengal Famine of 1943 for example, one of the worst famines of the 20th century, an estimated
16 lakh people died.
The reach of demand-supply analysis

is quite far and deep. Not only it
explains what happens in the market
for products like coffee, tea or
computers, it can shed light on very
complex socio-economic issues. In this
section, we apply it to understand how
famines occur.
A famine is characterised by
widespread death due to starvation and
epidemics.13 Epidemics typically result
from large scale starvation. Hence,
famine can be seen as a massive
incidence of starvation. In turn,
starvation is reflected mostly in the
staple food of the region. Therefore,
analytically, the question is how a large
section of a regions population cannot
afford to buy the minimum amount of
the staple food for survival.
The standard view is that it is
primarily a production or total
availability problem. We can define
total availability of a product as the
amount produced plus the amount
stored in government and private
warehouses. For reasons like natural
calamities and unfavourable weather
over critical months, the total
production of the staple food is
severely affected, which drastically
limits the total availability. As a result,
a large portion of a regions population
does not get the minimum amount for

survival and there is a large-scale
starvation. Professor Amartya Sen of
India, the only Nobel laureate in
economics in Asia thus far, calls this
the FAD theory, with FAD standing for
food availability decline.
In what follows, the FAD theory is
illustrated in terms of the demandsupply analysis. Professor Sens own
theory of famines is different. For those
who are interested, Appendix 3
illustrates his theory in terms of
the demand-supply analysis.14 See Clip
5-1 for a short bio-sketch of Amartya
Sen. 15
5.5.1 The FAD Theory
Let the staple food be called rice. Turn
to fig. 5.6, which depicts the individual
and market demand curves for rice as
well as the market supply curve of rice.
Let us say that there are three families,
A, B and C, in the market. The panels
(a), (b) and (c) graph their demand
curves respectively. The B-type familys
demand curve lies to right of that of the
A-type and the C-type familys demand
curve lies to right of that of the B-type.
We can interpret the A-type as the
poorest, the B-type as the next poorest
and the C-type, the richest.
14
15
16
17
97
Note that when the price of rice is

p1, the A-type family cannot afford to
buy any rice at all, but the B-type or
the C-type family can. As shown, this
price is above the point at which the
DDA, curve intersects the price axis.
Hence, the A-type familys quantity
demanded is zero. This is not true for
the B-type or the C-type family. The
former demands the amount B1, and the
latter the amount C1. If the market price
is p2 the A- and B-type families cannot
buy rice but the C-type can; its quantity
demanded is C2.16 Panel (d) depicts the
market demand curve, DD M as the
horizontal summation of the three
individual demand curves.
This graph assumes that there is
one family of each type. But it is not a
major assumption at all. If there are two
or more families of any given type, the
market demand curve is obtained by
horizontally summing the demand
curves of all families. The resulting
curve will look similar to DDM.
From the supply side, let the total
available amount initially be M0. It is
drawn vertical to represent that, after
the harvest, this is the total, potential
amount available for consumption.17
The equilibrium price is then p0. At this
price, all families are able to buy rice.
The types A, B and C respectively buy
The material on FAD theory and Sens own theory is based on Sen, A.K., Poverty and Famines: An
Essay on Entitlement and Deprivation, Oxford University Press, 1981. The demand-supply version
of these theories is the authors own copyrighted work, based on Theories of Famine: An Exposition,
mimeo, Indian Statistical Institute, April 2002.
It is hoped that some of you will be inspired, decide to study economics further in college and
eventually bag Nobel prizes for India.
If the price of rice is p3 or higher no one can buy rice; but such a price cannot prevail in equilibrium and
hence is irrelevant.
We can instead draw a standard upward sloping supply curve. But this will not change the analysis.
98
CLIP 5-1
By now Professor Amartya Sen is a household name in India. He was born in
Santiniketan in 1933. He studied in Calcutta University and later got his Ph.D.
from Cambridge University in 1959. Since then he has held
faculty positions in various prestigious institutions at home
and abroad such as Delhi School of Economics, Oxford
University, London School of Economics and Harvard
University. Currently, at this time of writing, he is the
Master of Trinity College at Cambridge University. He has
received more than forty honorary doctorates from major
universities around the world, and the Bharat Ratna award,
which is the highest civilian award in India.
He has published numerous books and articles, and, his
research has ranged over many areas of economics,
particularly welfare economics, and philosophy.
In awarding him the Nobel prize in 1998, the Royal Swedish
Academy of Sciences said that he had made several key
Amartya Sen
contributions to the research on fundamental problems in
welfare economics. His contributions range from axiomatic theory of social choice,
over definitions of welfare and poverty indices, to empirical studies of famine.
A0, B0, and C0. This situation can be

interpreted as normal, one in which
there is no starvation or famine.
Now suppose that, for some reason,
say, because of a bad monsoon, there
is less amount available, equal to M1.
The equilibrium price is higher, equal
to p1. Notice that at this price, the
poorest cannot afford to buy any rice,
but the other types can. We can think
of this situation as starvation:
Fig. 5.6
some people in the lower end of income

cannot just afford to buy enough food
for survival. If, instead, the total
available amount were much less
compared to the initial situation, e.g,
equal to M2, the price would have risen
to p2 and observe that at this price both
A-type and B-type families would be
out of the market. We can interpret this
as a situation of famine or massive
starvation. Whether exactly two types
FAD Theory of Famines
of families are deprived of the staple

food or not is immaterial. This situation
generally represents that a large
number of people are under starvation.
This is the FAD theory. In summary,
it says that a drastic fall in the total
availability of food causes massive
starvation and famine. The causal link
is that a large scale decline in food
supply pushes the market price up to
such a level that many poor people can
no longer afford to buy the minimum
amount for survival.
5.6
EFFICIENCY OF THE
PRICE MECHANISM AND
COMPETITIVE MARKETS
Many examples of demand and supply

shifts have been analysed. You should
not think, however, that such shifts are
confined mostly to these examples. The
chosen examples are the very obvious
ones. In a market economy, these shifts
occur almost always and in case of all
goods and services, but they occur
gradually over time.
At this point, it will be better if you
pause for a moment here and reflect
how the forces of demand and supply
and the price mechanism solve the
what problem in a market-oriented
economy.
Suppose for some reason, demand
for a product rises. This shifts out the
market demand curve (which is not an
observable physical object). It tends to
raise the market price that is observed.
The price change acts as a signal to
producers. They increase their quantity
supplied. The new equilibrium price is
higher. The consumers are able to buy
99
as much as they wish to, and, the

producers are able to sell as much as
they wish to at that price. The
adjustment is complete. You can
interpret the equality between quantity
demanded and quantity supplied as coordination between demanders and
suppliers through the price
mechanism. Unlike in a centrally
planned economy, there is no need for
a central authority to directly coordinate between the wants of millions
of consumers out there and the
production capabilities of the economy.
Things happen in a systematic way
by an invisible hand so-to-speak.
This is the beauty of the price
mechanism. In fact, it is said that price
mechanism is one of the fundamental
discoveries of the modern society.
Like all great discoveries, however,
the price mechanism has its own
drawbacks. As argued by Sen and
illustrated in Appendix 3, widespread
starvation can occur even when there
is no decline in the total availability of
foodgrains. This is potentially a serious
problem in a free market economy.
There are also other issues relating to
equity,
preservation
of
our
environment etc. that a free market
system cannot handle in efficient ways.
It does not however imply that a
severely restricted market system is the
right answer.
What are the drawbacks of the free
market system and what are their
corrective solutions? These are very
important questions. But we do not
examine them here. It is a subject
matter of higher courses in economics.
100
5.7 ECONOMIC POLICY BY THE

GOVERNMENT AND MARKET
EQUILIBRIUM
It is thought that if necessary items like

sugar, rice, wheat etc. were left to the
play of free market entirely, poor people
would not be able to afford them at the

market-clearing price.19 Hence, for a
long time, the government has adopted
a system of price control through ration
shops for such commodities.
In terms of demand and supply
curves, price control means fixing price
below the equilibrium price (as the
equilibrium price is presumed to be too
high). This is shown in fig. 5.7(a) and
denoted as P1. It is called the control
price. Since it is below the equilibrium
price (P0) the quantity demanded,P1D1,
exceeds the quantity supplied, P1S1,
This means that everyones demand, at
the given price, cannot be satisfied. It
implies the following:
1. There has to be some rationing
an upper limit on the amount that
can be purchased within a given
time period. This explains why
one cannot buy a large quantity
at a time from a fair -price or
ration shop.
(a)
(b)
Not only is market equilibrium affected

by the sources of demand and supply
shifts considered earlier, it is influenced
by various government policies as well.
There are some policies, e.g., different
kinds of taxes and subsidies, that
change the market price indirectly via
shifting the demand and supply curves.
Sales taxes and excise taxes are
common examples.18 These are called
indirect interventions. There are
other policies by which prices are fixed
directly by the government; these are
direct interventions. In what follows,
we study direct interventions only.
Price Control
Fig. 5.7
18
19
Price Control and Price Support
For example, in Delhi, the sales tax on pastries in the financial year 2001-2002 was 8% and that on
bicycles was 5%. In general sales taxes vary across states and range typically from 5 to 15%. Some
commodities are totally exempt from sales taxes.
This is similar to the famine theory discussed earlier.
2. Since there is a shortage at the

control price, there will always be
some buyers who are willing to pay
a higher price than the control price
and obtain the quantity that they
desire. This gives rise to the
existence of black markets.
Support Price
It is interesting that for the growers of
the same essential products, e.g., for
farmers who raise sugarcane, wheat
etc., there have been support price or
price support programmes, meaning
price being fixed above the equilibrium
price. These programmes are meant to
insulate farmers from income
fluctuations resulting from price
variations in the free market. Support
price is illustrated in fig. 5.7(b) and is
denoted by P2. Since this price is above
101
the equilibrium price (P0), opposite to

the price control case, the quantity
supplied (P2S2) exceeds the quantity
demanded (P2D2). There is always some
surplus. Who buys the amount of
surplus or excess supply, P2S2? It is
the government by committing to buy
the surplus at the pre-announced
support price.
It is noteworthy that while price
control programmes are commonly
observed in developing countries rather
than in developed countries,
agricultural price support programmes
have been common in both groups of
countries. However, many price support
programmes are being phased out now
in both developed and developing
countries,
because
of
their
commitments made to World Trade
Organisation as members.20
SUMMARY
l
l
l
20
Excess demand pushes up the market price by causing competition among the
buyers. Excess supply pushes down the market price by causing competition
among the sellers.
At the market equilibrium, there is no excess demand or excess supply and
demand and supply curves intersect.
A non-viable industry is one, in which the demand and supply curves do not
intersect at any positive level of output. The supply curve lies above the demand
curve and thus nothing is produced.
A rightward (leftward) shift of the demand curve leads to an increase (a decrease)
in price and quantity transacted.
While the intentions behind price control and price support programmes are well-meant, there is
considerable debate in economics literature about their efficiency in achieving the objectives, in
comparison to other policies that can achieve the same objectives. This is something that will be studied
in specialised courses in economics.
World Trade Organisation is an international body like United Nations, having more than 120 member
countries, whose objective is to promote free and fair international trade and commerce in the world
economy. It came to existence in 1995 and is headquartered in Geneva, Switzerland. India is a
founding member of WTO. China joined WTO in 2001.
102
l
l
l
l
l
l
l
l
l
l
l
l
l
l
A rightward (leftward) shift of the supply curve leads to a decrease (an

increase) in price and an increase (a decrease) in the quantity transacted.
If both the demand and supply curves shift to the right (left), the effect on
price is ambiguous but the equilibrium quantity exchanged increases
(decreases).
If the demand curve shifts to the right and the supply curve to the left, the
price rises but the effect on quantity exchanged is unclear.
An increase in the price of a substitute (complementary) good in consumption
leads an increase (a decrease) in price and quantity transacted of a good in
question.
An increase in income results in a higher (a lower) price and quantity
transacted according as the good is normal (inferior).
A favourable (an unfavourable) taste shift leads to a higher (a lower) price
and quantity transacted.
A cost reducing technological progress leads to a lower price and more
quantity being sold.
An increase in an input price leads to a higher price and less quantity being
sold.
An increase in the rate of excise duty leads to a higher price and less quantity
being exchanged of a particular product.
An increase in the price of a substitute good in production will lead to a
higher price and less amount exchanged of a particular product.
More competition in an industry leads to a lower price and a higher quantity
exchanged.
According to the FAD theory of famines, as the available quantity of foodgrains
falls, the price of foodgrains increases, such that families in the lower end of
wealth and income can no longer afford to buy it. This causes starvation.
The demand-supply equilibrium in a free market can be seen as co-ordination
between consumers and producers.
A price control system includes a rationing scheme since the quantity demanded
at the control price exceeds the quantity supplied of it. It also leads to black
marketing.
A price support system leads to a surplus of output, which is purchased by
the government.
EXERCISES
Section I
5.1
5.2
5.3
5.4
Give the meaning of excess demand for a product.

Give the meaning of excess supply of a product.
Define market equilibrium.
Give the meaning of equilibrium price.
5.5
5.6
5.7
5.8
5.9
5.10
5.11
5.12
5.13
5.14
5.15
103
For a non-viable industry, where does the supply curve lie relative to
the demand curve?
How does an increase in the price of a substitute good in consumption
affect the equilibrium price?
How does an increase in input price affect the equilibrium quantity
exchanged in the product market?
How does a favourable change in taste affect the market price and
the quantity exchanged?
How does a cost-saving technological progress affect the market price
and the quantity exchanged?
How does an increase in excise tax rate affect the market price and
the quantity exchanged?
When will an increase in demand imply an increase in price but no
change in quantity supplied?
What does the FAD theory of famines say?
What is the relationship between the control price and the equilibrium
price?
What is the relationship between the support price and the
equilibrium price?
Why does a surplus emerge in case of a support price?
Section II
5.16
5.17
5.18
5.19
5.20
5.21
5.22
Show the determination of market equilibrium with the help of

demand and supply schedules and a diagram.
What is meant by economic viability of an industry?
What will be impact on market price and the quantity exchanged
when
(a) there is a rightward shift in the demand curve ?
(b) the demand curve perfectly elastic and the supply curve shifts
out ?
(c) both the demand and supply curves decrease in the same
proportion ?
How does an increase in the income affect the equilibrium price of a
product?
A severe drought results in a drastic fall in the output of wheat.
Analyse how will it affect the market price of wheat.
Suppose the demand for jeans increases. At the same time, because
of an increase in the price of cotton, the supply of jeans decreases.
How will it affect the price and quantity sold of jeans?
Equilibrium price may or may not change with shifts in both demand
and supply curves. Comment.
104
5.23
5.24
5.25
5.26
5.27
5.28
5.29
5.30
5.31
How are decisions taken by consumers and producers in a market

co-ordinated?
Trace the effect of demand shifts on equilibrium price and quantity.
Given one example each of direct intervention and indirect
intervention in the market mechanism.
What do you understand by (a) control price and (b) support price ?
Show with the help of a diagram how rationing and black marketing
can emerge in a price-control system.
Answer all questions in terms of shifts in or movements along the
demand and supply curves.
(a)
In 2001, the Supreme Court of India banned smoking in public
places. How is this likely to affect the average price of cigarettes
and the quantity sold?
(b)
New discoveries of oil reduce the price of petrol and diesel.
Consider their effects on the market for new cars.
(c)
New environmental regulations require that the drug industry
use a more environment-friendly technology whose running
costs are higher but which discharges less toxic chemicals than
before. How would it affect the price of drugs?
China is a big manufacturer of telephone instruments. It has recently
become a member of WTO, which means that it can sell its product
in other member countries like India. Suppose that it does export a
large number of telephone instruments to India.
(a)
How will it affect the price and quantity sold of telephone
instruments in India?
(b)
Suppose that the demand for telephone instruments is
relatively elastic. How will it affect Indias total expenditure on
telephone instruments?
In the union budget for year 2002-2003, the excise duty on tea was
reduced from Rs. 2 per kg. to Rs. 1 per kg (this is a fact). All other
things remaining unchanged, how will it affect the market price of
tea?
Suppose the price controls on sugar are lifted. How, ceteris paribus,
will it affect the price and quantity consumed of sugar?
Section III
5.32
5.33
Mrs. Ramgopal says that economists say inconsistent things: as price

falls, demand rises, but as demand rises, price rises. Defend or refute.
Describe the FAD theory of famines.
OTHER FORMS
OF
MARKET STRUCTURE
CHAPTER
OTHER FORMS
6.1 Perfect Competition in

the Long Run: Free
Entry and Exit
6.2 Monopoly
6.3 Monopolistic
Competition
105
OF
MARKET STRUCTURE
The notion of market structure was

introduced in Chapter 4. A per fectly
competitive market structure is one that
has the following features: (a) there are a
large number of sellers and buyers in the
market, (b) the product is homogeneous and
(c) there is free entry and exit of firms in
the long run. In Chapter 4 we saw how (a)
and (b) lead to the supply curve, given that
the objective of a firm is to maximise profits.
In Chapter 5 we studied the interaction
between supply and demand curves, and,
learnt how the price/market mechanism
works.
In this chapter we study market
structures as such. Having already analysed
the implications of (a) and (b) under perfect
competition, we begin by analysing the
implications of feature (c), i.e., perfect
competition in the long run.
There are other market structures, which
are not perfectly competitive. They go under
the name of imperfect competition or
imperfectly competitive market. There are
three broad forms of imperfectly competitive
markets:
monopoly,
monopolistic
competition and oligopoly. In this chapter,
we analyse the first two.
106
6.1 PERFECT COMPETITION IN

THE LONG RUN: FREE ENTRY
AND EXIT
Before analysing the implications of free
entry and exit, we discuss a couple of
things.
1. Recall from Chapter 3 that there
are no fixed costs in the long run.
Moreover, both the Long run
Average Cost (LAC) and the Long
run Marginal Cost (LMC) curve are
U-shaped. The pattern of returns to
scale that is, initially at low levels
of output, a firm would experience
increasing returns to scale, followed
by constant returns to scale and
diminishing returns to scale
implies the U-shape of LAC curve,
which, in turn, implies the U-shape
of LMC curve.
2. How does producers equilibrium
or profit-maximisation happen in
the long run? The answer is that it
happens the same way in principle
as in the short run. Profit is
maximised when P = LMC. The
economic logic behind it is also
parallel to that in the short run.
We are now ready to examine the
effects of free entry and exit.
Suppose that the market price of
the product is P1, and the firms are
producing at the point where the
price line intersects the LMC curve.
Moreover, suppose that the price, P1,
is high enough such that, at the profitmaximising level of output, firms are
making positive profits. In economics,
a positive profit is sometimes referred
to as abnormal profit, in the sense
that the total cost is assumed to
include not just the production costs

but also the opportunity cost of the
producer herself and hence profits
are equal to the producers excess
earning over her opportunity cost.
(Likewise, negative profits, that is,
losses are called abnormal losses.)
In this situation, abnormal profits
will attract many new firms to the
industry. This will shift the market
supply curve to the right, driving down
the market price and profits. Another
way to look at it is that there will be
more competition, which will lower price
and profits. How far will this continue?
It will happen till there are no abnormal
profits.
Similarly, if, initially, the price is low
enough such that firms are incurring
losses, free exit means that some
existing firms will start to quit the
industry. This will tend to shift the
market supply curve to the left. The
price will rise. Losses will be less. The
exit process will continue till there are
no losses.
It then follows that free entry and
exit imply zero profit in equilibrium.
Note that profit being zero is equivalent
to P = LMC . This is the break-even
price, the price at which the abnormal
profit is zero. We can then say that free
entry and exit imply that in the long run
the market price will be equal to the
break-even price.
Together with the profit maximising
condition P = LMC, the long-run
competitive equilibrium is then
defined by
P = LMC = LAC.
OTHER FORMS
OF
MARKET STRUCTURE
That is, at the long run equilibrium,

firms are in equilibrium (i.e. they are
maximising profits) and there is no
entry or exit.
This is illustrated in fig. 6.1.
Panel (a) shows that a firm produces
the output qL. At this level of output,
both the marginal cost and the average
cost are equal to the price pL. Abnormal
profits are zero, as price equals average
cost. Implicit in this panel is that there
is an equilibrium number of firms, not
too many or too few, which is
consistent with profits being zero.
However, it is not possible to see what
this number is in this diagram. See
Exercise 6.47 for a numerical solution.
Fig. 6.1(b) depicts the long-run
market supply curve (with the number
of firms being equal to its equilibrium
value) and the demand curve. Market
equilibrium occurs at price pL. The total
equilibrium quantity produced and
exchanged is QL .
There is an important property
associated with a perfectly competitive
market in the long run equilibrium.
(a)
107
That is, the firm produces at a level

(qL),where the LAC is at the minimum,
i.e., production occurs at the most
efficient scale. The firms scale of
operation is large enough such that
the benefits of increasing returns to
scale have been realised, but it is not
that large so as to incur the problems
associated with decreasing returns to
scale.
6.2 MONOPOLY
Some of you must have heard this
term before. Mono means one,
poly means seller and thus
monopoly means one seller. This is
defined in the context of a given
geographical location or space. In
India, before liberalisation in the power
sector got underway in the 1990s, the
generation, transmission and
distribution of electricity were in the
hands of State Electricity Boards
(SEBs). The SEBs were monopolies in
the respective states.
To take another instance, you hear
many people use the term xeroxing
(b)
Fig. 6.1 Firm and Market Equilibrium in the Long Run
108
CLIP 6.1
Patent Laws
Most developed countries have comprehensive patent laws. During the patent
life the patent holder can sell license to other firms for using its technology
(legally). Typically, the license is sold to firms who operate in markets other
than where the patent holder operates, e.g., in a different country. The
enforcement of patent law is also strict in developed countries. A patent holder
can take to court some other firm, who may be using its technology without a
license, and get a fairly quick decision.
In India, the patent law and its enforcement are rather passive. This is because
research and development, discoveries and inventions have not been a focus of
activities by firms. Barring a few exceptions, we generally import technology from
abroad.
The most important patent legislation in India is the Indian Patent Act of 1970. It
provided that any invention of a new product or a process of production, which is
useful and not obvious, is patentable. But it explicitly did not allow product patents
in the drug and food sector. This allowed Indian drug companies to produce drugs
invented in the developed countries and sell them in less developed countries. Cipla,
an Indian drug company, is an example. For a long time, Cipla has supplied antiAIDS drugs, named Combivir, to a country like Ghana.
Recently however, as an obligation of being a member of WTO (World Trade
Organisation), India and other countries had to revamp their patent laws. In India,
a major amendment to the Patent Act of 1970 was done in 1999, by which both
product and process patents are allowable in the food and drugs sector. In general,
patents are being protected more aggressively than before.
To continue our account of Cipla selling Combivir in Ghana, a multinational company
named Glaxo Smith Kline claimed that it had patents on the generic version of drug
Combivir and it filed a patent violation complaint against Cipla in Ghana. After the
hearing of arguments by both companies, the government of Ghana in 2000 rejected
Ciplas application to market this drug in Ghana.
There is a fear in India that, because of our being a member of WTO, we are forced
to honour patent protection. As a result, particularly in the drug sector, Indian
companies will no longer be able to sell many essential drugs at affordable prices.
Once multinational companies start to sell them, the drug prices are going to skyrocket, and many poor people will be denied access to these drugs.
Are patents a good thing for a developing country like India? Should India be a
member of WTO? An immediate reaction may be a no to both. However, a careful
and rational thinking might suggest just the opposite. We recommend you to
visit WTOs website, http://www.wto.org and read many articles on these issues.
OTHER FORMS
OF
MARKET STRUCTURE
to mean the use of a photocopying

machine. Actually, Xerox is an
American company, which discovered
the plain-paper photocopying machine
in 1959. It obtained patent on it. (The
concept of patent will be explained
shortly.) Throughout the 1960s it was
the only company that manufactured
and sold plain-paper photocopying
machines.1 This is an example of a
private monopoly.
A monopoly is the opposite of the
per fectly
competitive
market
structure: there is just one firm/seller
instead of many. There is little
competition. It is implicit that there are
no close substitutes to the monopolys
product or service available in the
market. It is also implicit that there is
no free entry (otherwise, more than one
firm can operate in the industry).
A monopoly market structure emerges
because of any of the following
reasons.
(a) The government gives license to
only one company for producing a
product or providing a service in a
given locality or space. For
instance, till 2002, VSNL (Videsh
Sanchar Nigam Limited) had
monopoly in India in providing
international telephony service.
(b) Big private companies typically
in developed countries engage in
research and come up with new
1
109
products or new technology in

producing an existing product. As
a reward for their risk and
investment in research, they can
apply to their government for a
patent, which is an of ficial
recognition that they are the
originators of the new product or
technology and no one else can use
their technology without obtaining
license from them. In other words,
monopoly arises because of
granting patent certificate or what
is called patent rights. The case of
Xerox is an example.2
However, patents are not granted
for ever. They are valid only for a
certain number of years (after
which other firms can freely copy
the technology). This period is
called patent life. In most
developed countries the patent life
varies between 15 to 20 years. In
Australia it is 20 years; in the
U.S. it is currently 17 years. See
Clip 6-1 on patent laws.
(c) Sometimes, fir ms retain their
individual identity but they coordinate their outputs and pricing
policy so as to act as if it is a
monopoly. This is called a cartel.
The OPEC (Organisation of
Petroleum Exporting Countries) in
the 1970s is an example of a cartel
that led to virtual monopoly in the
Plain-paper photocopy machine has been regarded as the most successful commercial product in
history. Now there are many well-known companies, besides Xerox, in the world market that produce
photocopying machines, e.g., Canon, Mita, Panasonic, Ricoh, Royal, Sharp and Toshiba. Many fax
machines also have copying capability.
Another example is a drug company called Eli Lilly, which has a patent on a very widely used
antidepressant called Prozac. This patent is supposed to expire in 2003.
110
world market for oil. See Clip 6-2

for a brief history of the OPEC and
the world oil market.3
6.2.1 Total, Average and Marginal
Revenues
The objective of a monopolist is to
maximise its total profit, which, by
definition, equals total revenue minus
total cost. The cost structure facing a
monopolist is similar to that of a
competitive firm. We have the same
concepts, total cost, average cost,
marginal cost etc., and their general
shapes are also the same as for a
competitive firm. But the revenue
structure facing the monopolist is
quite different.
Recall that a perfectly competitive
firm is very small compared to the
market. It does not have any market

power and thus it is a price-taker. None
of this is true for a monopoly since it is
the only producer by definition. It has
market power and it is a price-maker
so-to-speak. This is the most important
difference of a monopoly firm from a
perfectly competitive firm. It implies that
the way total revenue changes as
output changes is different from what
happens to a perfectly competitive firm.
In case of the latter, we already know
that, as output increases, the price
remains unchanged. But a monopoly
firm faces the entire market, hence faces
the market demand curve. Hence, as it
increases or decreases its output it
cannot expect that the market price
remains unchanged: price will change
according to what consumers are
Clip 6-2
OPEC and The World Oil Market
OPEC had five founding members: Iran, Iraq, Kuwait, Saudi Arabia and Venezuela.
It came into existence in 1960. Qatar joined it in 1961, followed by Indonesia and
Libya in 1962, United Arab Emirates in 1967, Algeria in 1969 and Nigeria in 1971.
In the 1970s when the first oil price shock overtook the world economy, OPEC
consisted of the above-mentioned countries. (Currently there are two other countries
in OPEC, namely, Ecuador and Gabon.) The aim of the OPEC countries is to set
production quotas, so as to manipulate the price of petrol in the world market.
Besides the OPEC, there are other countries which are major producers of oil. For
example, America was and still is, a big producer of oil. But its consumption is even
greater and thus it is an importer of oil. India also produces oil and is an importer.
Hence, in the import-export market, OPEC in the 1970s can be interpreted as a
monopoly.
The oil shortage of 1970s motivated many other countries to explore oil. By mid
1980s there were other countries, who were major exporters of oil and who used to be
importers of oil earlier, e.g., Mexico, The Netherlands and Russia.
3
There are other reasons for monopoly or near-monopoly also, e.g., merger and acquisition. In the early
1990s, in the tea industry, Brooke Bond and Lipton merged and subsequently they merged with
Hindustan Lever. It left out Tata, another large tea firm.
OTHER FORMS
OF
MARKET STRUCTURE
willing to pay along the demand curve.

The monopolist has to take this into
account. Put differently, the market
demand curve is a constraint facing a
monopoly firm. This point must be
understood very clearly.
Suppose, the market demand
schedule is as given in Table 6.1. Since
the monopolist faces this demand
schedule it means that if she wants to
sell 4 units for example, she (the
monopolist) must charge price equal
to Rs. 7. The reason is as follows. If
she charges any price higher than
Rs. 7, she will be able to sell only less
than 4 units. Moreover, as long as she
wants to sell 4 units, she can sell them
all by charging Rs. 7 each because
along the market demand curve 4 units
are demanded at the price equal to
Rs. 7. Therefore, there is no reason to
sell at any price less than Rs. 7.
Similarly, it can be argued that if the
monopolist wants to produce and sell
5 units, the price charged will be Rs. 5,
and so on.4
We can then write Output or
Quantity in place of Quantity
Demanded and present the same
demand schedule with output listed
in increasing order, starting with
output equal to 0 (and corresponding
price equal to Rs. 15). This is done along
the first two columns in Table 6.2. These
two columns represent the same
111
demand schedule as in Table 6.1. Now,

by multiplying output by price, we get
the Total Revenue (TR), which are given
in column (3). Dividing TR by output
gives average revenue, AR, since, by
definition, AR = TR/output. This is
Table 6.1 A Demand Schedule
Price
(in Rs.)
Quantity Demanded
(units)
11
13
15
shown in column (4). TR being equal

to price output, AR = price output/
output = price, that is, AR is equal to
price.5 Thus the entries in column (4)
are same as those in column (2). Also
recall from Chapter 4 the concept of
Marginal Revenue (MR), defined as the
addition to the total revenue from one
extra unit sold. The last column gives
the MR schedule.
Hence, unlike what many, especially non-economists, believe, a monopolist despite having market
power, cannot not just charge any price at its sweet will. It could have, only if the demand curve were
totally vertical, i.e., there were absolutely no substitutes available. But for most products substitutes
are available.
This is true except when output is zero. At zero output, TR/output = 0/0, which is not defined.
112
We note the following properties of the

three revenue concepts.
1. MR decreases with the output.
Initially it is positive and after a
Table 6.2 TR, AR and MR under
Monopoly
Output Price
(Rs.)
TR
(Rs.)
AR
(Rs.)
MR
(Rs.)
15
13
13
13
13
11
22
11
27
28
25
-3
18
-7
-11
certain level of output it becomes

negative.
2. TR increases or decreases as MR is
positive or negative.
3. TR first increases with output and
then it decreases. Therefore, if we
graph TR against output (i.e. the
TR curve), it rises initially and then
falls. This is because MR is initially
positive and then negative.
Moreover, it means that, if output
is measured on a continuous
scale, TR reaches maximum when
MR = 0. Thus the shape of the TR
curve facing a monopoly firm is
quite different from that facing a
competitive firm.
4. Since AR = price, if we wish to graph

the AR curve, it is always same as
the demand curve facing the firm.
5. Except for the first unit, at all other
levels of output, MR < AR. This
follows from the relationship
between average and marginal
discussed in Chapter 3, that is, if
average is falling (rising),
marginal is less (greater) than the
average.
Panels (a) and (b) of fig. 6.2
respectively graph the TR curve, and
the AR and MR curves corresponding
to Table 6.2. The TR curve is inverse
U-shaped as TR initially increases and
then decreases with output.
(a)
(b)
Fig. 6.2 The TR, AR and MR Curves
corresponding to Table 6.2
OTHER FORMS
OF
MARKET STRUCTURE
Fig. 6.3 depicts a smooth

hypothetical TR curve and the
associated AR and MR curves. As you
can notice, TR reaches its maximum
when MR = 0.
(a)
(b)
Fig. 6.3 Smooth TR, AR and MR Curves
6.2.2Profit-Maximising Rule
A full analysis of a monopolys
profit maximisation or producers
equilibrium is beyond our scope here.
But we can state its condition:
(A)
MR = MC.
That is, a monopolist maximises
profit by selecting the level of output at
which MR = MC.
This is indeed a very general
condition of profit maximisation by a
firm. (It was noted in Chapter 4 also.)
Recall that for a competitive firm
MR = P and thus the condition P = MC
is a special case of the general condition
MR = MC.
113
The condition (A) is quite intuitive.

At very low level output, MR will exceed
MC. Since, by definition, these are
respectively equal to additional
revenue and additional cost, as long as
MR > MC, a marginal increase in output
will fetch additional revenues, which
will be more than the additional cost
involved in increasing the output. Thus
the firm will obtain more profits if it
increases its output. On the other hand,
at a very large level of output, MC will
be very high and MR very low (possibly
negative). This means that, if the firm
reduces output, the savings in cost will
be greater than the revenues lost and
hence profits will be higher. Therefore,
profit is maximum at the level of output,
where MR = MC.
6.2.3 Monopoly Versus Perfect
Competition
These are the following general and
important features of monopoly in
comparison to perfect competition.
1. In perfect competition profit
maximisation leads to a supply
curve which tells how much a firm
produces at different market prices
that are given to the firm. In
monopoly, however, the fir m
decides output and price. There is
no question of the optimal level of
monopoly output at different prices.
Hence there is no supply curve as
such under monopoly.
This does not mean however that
demand and supply forces do not
interact. They do. Shifts in the
Demand Curve (AR) or in the MC
curve do affect a monopolists
output and price.
114
2. In perfect competition there is a

major difference between short run
and long run. Not only are cost
curves different (because there are
no fixed costs in the long run),
there is free entry and exit, which
drives profits to zero in the long
run. In contrast, in monopoly, by
definition, there is no entry and
exit. Hence, essentially, there is not
much analytical difference between
short run and long run.6
3. Now we come to the most important
behavioural difference between
monopoly and perfect competition.
We already know that, for a
monopoly, P > MR and it selects
an output level where MR = MC.
These two relations imply that
P > MC, that is, while price is
equal to marginal cost in perfect
competition, the price exceeds
marginal cost under monopoly. It
means that a monopoly, in a sense,
charges too high a price for its
product. Moreover, the monopoly
price being higher than the
competitive price, it follows that,
along a given demand curve, less is
sold and therefore less is
produced under monopoly than
under perfect competition. In
summary, we can then say that the
monopolist produces less and
charges a higher price, compared
to perfect competition.
6
The last point summarises what is

wrong with a monopoly market
structure. It is the basis of negative
sentiments against a monopolist,
which arises from time to time and
which flares up to a slogan that a
monopolist exploits the public and
hence should be regulated and
discouraged.
6.2.4 MERITS OF MONOPOLY
But before we rush to this conclusion
we should note some good things
about the monopoly too.
1. Suppose that initially there are two
firms in an industry and both are
somewhat inefficient. Their MC
curves are at a high level and
consequently they charge a higher
price and produce less than what
they would if the MC curves were
at a lower level. They realise,
however, that if they merge with
each other and thereby become a
monopoly they can reduce their
costs. For instance, one firm may
have excellent technical manpower
but may not have good marketing
skills, whereas the other may not
have good technical manpower but
possesses superior marketing
knowledge. By merging, the
resulting monopoly firms MC curve
will be at a lower level and thus it
will be a more efficient firm. This,
by itself, will induce the monopoly
However, it is quite possible and likely that over a long period the monopolist loses its monopoly
power. For example, if the monopoly is present, in the first place, by virtue of a patent, the patent
eventually expires and other firms use the same technology and there is competition. But the point
is that as long as there is monopoly, there is little analytical difference between short run and long
run in terms of output and price determination.
OTHER FORMS
OF
MARKET STRUCTURE
to charge a price, which is less, and

produce a quantity, which is greater
than when both firms were
competing with each other. This is
a good thing about monopoly.
On the other hand, the resulting
monopoly will be in a position to
exercise greater market power and
charge the monopoly price. We
already know that this is a bad
thing. Hence, there is a trade-off
between efficiency and market
power. If ef ficiency gains are
suf ficiently strong, then a
monopoly serves the society better
and hence is preferable.
Many countries including India
have the so-called anti-trust
legislations to deal with this issue.
The objective of this legislation is
to permit mergers, acquisitions
and business practices that have
strong ef ficiency ef fects and
prevent those, which are meant to
create or enhance market power
accompanied by little efficiency
gains.7
2. Another major benefit from
granting monopoly is that
monopoly power and profits
provide incentives for inventions
and innovations. In reality, these
activities
are
very
risky
propositions. Often times they
materialise from individual efforts
and persistence. Why would
7
8
115
someone invent a product if he/she

is not allowed to enjoy monopoly
profits for a few years? As
mentioned earlier in the chapter,
this is indeed the essence behind
granting patents.
These two points together with the
inherent property of the monopoly
market structure that price exceeds
marginal cost imply that economic
policy toward monopolies is a subtle
practical issue that should be handled
with care rather than be governed by
simplistic and often populist view
that all private monopolies are bad.
6.3 MONOPOLISTIC COMPETITION
This is an interesting market structure,
in which both competitive and
monopoly elements are present. Its
features are the following. (a) There are
a large number of sellers and buyers.
(b) There is free entry and exit in the
long run. Moreover, (c) there is product
differentiation. That is, each firm
produces a brand or variety (of the same
product) that is unique, i.e., different
from what any other firm produces. The
varieties produced are very close
substitutes of one another. Products
like toothpaste, soap and lipstick are
prominent examples.8
Features (a) and (b) are competitive
features. (a) states that each firm is small
relative to the market. (b) implies that
firms earn zero abnormal profits in the
In India, the MRTP Act of 1969 is the land-mark anti-trust legislation.

For example, at the point of writing this book, there are 7 brands of lipstick available in the Indian
market: Avon, Elle, Lakme, Loreal, Maybelline, Revlon and Tips & Toes. There are many more brands
of toothpaste, e.g., Acquafresh, Anchor, Amar, Babool, Cibaca, Close-Up, Colgate, Forhans, Meswak,
Neem, Pepsodent, Promise and Vicco Bajradanti.
116
long run. However, (c) is a monopoly

feature in the following way. Even
though a firm is small and produces a
brand that has many close substitutes,
yet it is a unique brand. No one else
produces exactly the same brand. In
other words, there is only one firm
producing a given brand. In this sense,
each firm has some monopoly power.
The last point means that a
monopolistically competitive firm also
faces AR and MR curves for its brand
and it maximises profits at the level of
output, where MR = MC. Moreover, it
charges a price, which exceeds
marginal cost.
Analytically, all these are analogous
to the case of monopoly, except for one
qualitative difference. That is, since there
are close substitutes available for any
particular brand, the demand curve
facing a monopolistically competitive
firm (unlike that facing a monopoly
firm) is very elastic, implying that the
AR curve must be quite flat.
There is, however, a major difference
between monopolistic competition and
monopoly in the long run. Unlike in
monopoly, there is free entry and exit,
which implies that abnormal profit is
driven to zero. As we have already seen,
this is equivalent to P = LAC, where the
letter L refers to the long run. Together
with the profit maximising condition
MR = LMC we can then compactly write
the long-run equilibrium conditions in
monopolistic competition as
MR = LMC;
P = LAC.
9
Although the features of monopolistic

competition are a combination of
perfect competition and monopoly, in
terms of decision-making, there is one
aspect of it, which is different from both
perfect competition and monopoly.
That is, monopolistically competitive
firms typically engage in advertising,
i.e., they incur advertising costs or
what is also called selling costs. It is
because of the need to maintain a
perception in the mind of the potential
consumers that their respective brands
are different (and more tasteful or
classy), compared to other brands. This
is persuasive advertisement and its
purpose is to lure away consumers from
other brands. In perfect competition,
the product is perfectly homogeneous
and hence there is no scope to
engage in persuasive advertisement.
In monopoly, since there is no
competition, there is no need to
engage in persuasive advertisement.
Realise that such selling costs do
not benefit the consumers as a group:
they only serve to move consumers one
brand to another. But they involve
resources, which can be potentially
used for production. Therefore, such
costs are wasteful from the viewpoint
of the society.9
This closes our analytical
discussion on market structure. As
said in the beginning of this chapter,
we leave out one important form of an
imperfectly competitive market,
namely, oligopoly. See Clip 6-3 for a
brief description of oligopoly.
Not all advertising costs are wasteful. There can be informative advertising (e.g. information about
health), which is useful for the consumers.
OTHER FORMS
OF
MARKET STRUCTURE
117
CLIP 6-3
Oligopoly
A market in which there are a few (two or more) number of large firms is called
oligopoly. (The firms in it may be producing a homogeneous product or a differentiated
product.) As a special case, if there are only two firms, then it is called a duopoly
market. From an analytical perspective, what distinguishes oligopoly from other
market structures is strategic interaction among firms. Since there are only a few
number of firms, a particular firm, in choosing its output or price, has to take into
account what the other firms are choosing and how they may react to its choices.
This is a subject matter of a higher course in microeconomics.
SUMMARY
l
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Imperfectly competitive markets are of three types: monopoly, monopolistic

competition and oligopoly.
The long run profit-maximising condition is essentially same as the
short run profit-maximising condition. For a perfectly competitive firm,
it is price being equal to the long run marginal cost.
Free entry and exit imply zero profit, i.e., price is equal to the long run
average cost. Firms break-even.
The long run competitive equilibrium is characterised by the conditions:
P = LMC = LAC.
In the long run with free entry and exit, a perfectly competitive firm operates
at the level where the long run average cost is at its minimum.
A monopoly market structure emerges from licensing, granting of a
patent or forming a cartel.
A monopoly is a price maker.
The market demand curve is a constraint facing a monopoly firm.
For a monopoly firm, TR first increases and then decreases with output.
For a monopoly firm, TR reaches its maximum when MR = 0.
For a monopoly firm, MR typically decreases with an increase in output.
MR = MC is indeed a very general condition for profit maximisation by
any firm.
Unlike in perfect competition, price exceeds marginal cost in monopoly.
In comparison to a perfectly competitive industry, in monopoly a higher
price is charged and less is sold.
Formation of monopoly may lead to more efficiency (in the form of lower
costs).
Patents encourage discovery and invention.
118
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A monopolistically competitive firm typically faces a very elastic demand

curve for the brand it produces.
The long run equilibrium in monopolistic competition is characterised
by the conditions, MR = LMC and P = LAC.
Monopolistically competitive firms engage in advertising costs to lure
away customers from other brands to their own brands.
EXERCISES
Section I
6.1
6.2
6.3
6.4
6.5
6.6
6.7
6.8
6.9
6.10
6.11
6.12
6.13
6.14
6.15
6.16
6.17
6.18
6.19
Name the three forms of imperfectly competitive markets.

What is the profit-maximising condition of a competitive firm in
the long run?
What is meant by abnormal profit?
What is meant by abnormal loss?
If the firms are earning abnormal profits, how will the number
of firms in the industry change?
If the firms are making abnormal losses, how will the number of
firms in the industry change?
What is the relationship between marginal cost and average cost
at the long run competitive equilibrium?
State the conditions of long run equilibrium in a perfectly
competitive industry.
What is break-even price?
What is the relationship between break-even price and marginal
cost at the long run competitive equilibrium?
Which point on the long run average cost curve does a
competitive firm produce in the long run equilibrium?
How many firms are there in a monopoly market?
What are patent rights?
What is patent life?
What is a cartel?
How does the total revenue change with output when the
marginal revenue is positive?
How does the total revenue change with output when the
marginal revenue is negative?
What is the relationship between the average revenue curve and
the demand curve in a monopoly market?
What is the profit-maximising condition for a monopoly firm?
OTHER FORMS
6.20
6.21
6.22
6.23
6.24
6.25
6.26
6.27
6.28
6.29
6.30
6.31
6.32
6.33
6.34
OF
MARKET STRUCTURE
What is the shape of the total revenue curve in monopoly?

What is the shape of the average revenue curve in monopoly?
What is the shape of the marginal revenue curve in monopoly?
What is the profit-maximising rule for a monopolist?
What is the relationship between price and marginal cost at the
monopoly equilibrium?
How do the equilibrium monopoly output and price compare
with the equilibrium price and output in perfect competition?
What are anti-trust legislations?
Which feature/features of monopolistic competition is/are
monopolistic in nature?
Which feature/features of monopolistic competition is/are
competitive in nature?
Give two examples of a monopolistically competitive market?
State the conditions of long run equilibrium in a monopolistically
competitive industry.
What is the relationship between price and marginal cost in a
monopolistically competitive market?
What are selling costs?
What are advertising costs?
What is persuasive advertising?
Section II
6.35
6.36
6.37
6.38
6.39
6.40
6.41
6.42
6.43
Explain how in the long run equilibrium with free entry and
exit, firms, under perfect competition, earn zero abnormal
profits.
Explain why the marginal revenue is less than average revenue
for a monopoly firm.
Explain how the market demand curve is a constraint facing a
monopoly firm.
Discuss various ways in which a monopoly market structure
may arise.
Explain how the efficiency may increase if two firms merge.
Explain the motivation behind granting patent rights.
Briefly discuss the features of monopolistic competition.
Why is the demand curve facing a monopolistically competitive
firm likely to be very elastic?
Explain how price exceeds marginal cost in monopoly or in
monopolistic competition.
119
120
6.44
Explain how in the long run equilibrium with free entry and
exit, firms, under monopolistic competition, earn zero abnormal
profits.
Section III
6.45
The demand schedule facing a monopoly is given below. Derive

its TR, AR and MR schedules.
Price (Rs.)
6.46
Quantity Demanded (units)
10
20
30
40
50
60
70
The MR schedule of a monopoly firm is given below. Derive the

TR and AR schedules.
Output (units)
MR (Rs.)
14
10
OTHER FORMS
6.47
OF
MARKET STRUCTURE
The technology is such that the long-run average cost is

minimised at the firm output equal to 10 and the minimum longrun average cost is Rs. 15. Suppose that the demand schedule
for the product is given as follows.
Price (Rs.)
(a)
6.48
121
Aggregate Quantity Demanded
10
1800
12
1440
15
1200
18
1000
20
760
What will be total quantity sold in the market and how many
firms will operate in the long run competitive equilibrium?
(b) Suppose that, because of technological progress, the average
cost curve shifts down such that the minimum average cost
is equal to Rs. 12 and it occurs at output level 8. How many
firms will now operate in the market in the long run?
Explain why MR = MC is the profit-maximisation principle of a
firm in general.
U N I T-V
FACTOR PRICE DETERMINATION
CHAPTER
123
7.1 Factor Demand
7.2 Total Factor Demand,

Factor Supply and
Equilibrium
7.3 Trade Unions
In Chapter 2 to Chapter 6, we examined the

product markets: which good or service will
be produced, and if so, how much and what
its price will be. In other words we dealt with
the central problem of what facing an
economy. Households are demanders and
firms are suppliers in product markets.
In this chapter we examine factor or input
markets, e.g., different types of labour or skill,
capital (i.e. machinery and equipment), land
etc. In factor markets, firms are demanders
and households are suppliers.
There are similarities and dissimilarities
between product and factor markets.
Dissimilarities arise because the demanders
and suppliers in a factor market are opposite
of who they are in a product market. The
issues are different also. Instead of the
economys central problem of what, the
factor market analysis sheds light on the for
whom problem. For example, consider the
labour market. The price of labour service is
the wage rate. We will learn how the wages to
different types of labour are determined in a
market economy. In general, earnings to
different individuals in the form of wage
income or income from land etc. determine
income distribution in an economy. Income
distribution, in turn, determines differences
124
in the purchasing power over goods and

services among individuals or
households. This is how the factor
market implications are linked to
central problem of for whom.
The similarity between factor and
product markets lies in that there is a
demand side and there is a supply side
of a factor. The equality between
demand and supply of a factor
determines the respective factor price.
7.1 FACTOR DEMAND
7.1.1 A Firms Problem
At a given point of time, a firm faces
different prices for different factors. For
instance, think of a transport and
storage company. It employs workers,
rents warehouse space for storage etc.
The prevailing hourly wage rate may be
Rs. 15. Warehouse facility may be
available at the rate of Rs. 50 per day
per cubic metre of space. The question
is, given factor prices, how much of
different factors a profit-maximising
firm should hire?
On one hand, hiring more of factors
will generate more output, which will
generate more revenues (as long as the
marginal revenue is positive). On the
other hand, hiring more factors will
cost more.
7.1.2 One Variable Factor
To begin with, suppose that the
employment levels of all factors,
except one, are fixed, i.e., there is only
one variable input and the rest are
fixed. Let this variable factor be called
labour, measured in hours of work.
(If all workers are supposed to work a
given number of hours per day, then

we can measure labour as the number
of workers hired.) In other words, we
are not differentiating between
different types of workers at the
moment. The question is, how many
labour hours (denoted by L) a firm
should employ?
The total cost of fixed factors is
fixed by definition. The total cost of
the variable factor (labour in our
example) is easy to compute.
Suppose that the wage rate is Rs. 20
per hour. If the firm hires 4 hours of
labour, the total cost of labour is Rs.
20 4 = Rs. 80. If 7 hours of labour
are hired, the total cost of labour or
the total wage bill is Rs. 20 7 = Rs.
140, and so on.
The way a firms total revenue
changes with employment of a factor
contains two steps: (a) how changes
in the employment of the factor affect
output and (b) how changes in output
affect total revenue. Realise that we
have already studied (a) in Chapter 3.
We also have analysed (b) for a
competitive firm in Chapter 4 and for
a monopoly firm in Chapter 6.
What we need to do then is to combine
what we have already learnt.
For simplicity, let us assume
throughout this chapter that the firm
under consideration is a perfectly
competitive firm.
From Chapter 3, recall in particular
the definitions of Total Physical Product
(TPP) and the
Marginal Physical
Product (MPP). The former refers
to different levels of total output
at different levels of employment
125
of a factor, when the employment of

other factors is unchanged. The latter
is the increase in total output per
unit increase in the employment of a
factor when the employment of all
other factors is held constant. From
Chapter 3, we also know the shapes of
the TPP and MPP curves. In particular,
the inverse U-shape of the MPP curve
follows from the law of diminishing
returns.
We need two more concepts before
we are able to answer in principle the
question of how much of a factor a
profit-maximising competitive firm will
employ. The first is the Total Value
Product (TVP), defined as P TPP,
where P is the product price. This is
indeed same as total revenue. The
Table 7.1
second one is the Value of the

Marginal Product (VMP), defined as P
MPP. Equivalently, VMP is equal to
the increase in TVP or total revenues
per unit increase in the employment
of the factor. It is because an extra unit
employed of a factor generates extra
output equal to MPP, which will fetch
extra revenues equal to the value of this
extra output.
Consider the TPP schedule and the
MPP schedule, as given in Tables 3.2
and 3.3 in Chapter 3. In order to
calculate the TVP and the VMP, we
need to know the product price.
Suppose that P = Rs. 2. Table 7.1 gives
the TPP schedule, the MPP schedule
as well as the associated TVP and VMP
schedules.
TPP, MPP, TVP and VMP Schedules
Labour Hours
(L)
TPP
MPP
TVP = P.TPP
(Rs.)
VMP = P.MPP
(Rs.)
10
10
20
20
22
12
44
24
33
11
66
22
43
10
86
20
51
102
16
56
112
10
56
112
48
96
16
36
12
72
24
Product Price = Rs. 2
126
Particularly relevant for us will be the

VMP schedule and its properties.
A. It is proportional to the MPP schedule
as it is obtained by multiplying the
MPP schedule by price, which is
constant. This implies that the law
of diminishing returns, which
governs the nature of the MPP
schedule, also determines the nature
of the VMP schedule. It initially
increases with factor employment
and then diminishes.
B. TVP of a particular level of factor
employment is the sum of VMPs up
to that level of employment. For
instance, at L = 3, TVP = 66. This is
equal to the sum of VMPs at L = 1
(20), at L =2 (24) and at L = 3 (22).
Property A implies that the VMP
curve, the graphical representation of
a VMP schedule, will be inverse Ushaped, just as the MPP curve. This is
illustrated in fig. 7.1(a). Property B
implies that, if we draw a smooth VMP
curve, the area under it will be equal
to the TVP (i.e. the total revenue). A
general, smooth VMP curve is shown
in fig. 7.1(b). For instance, at L = L1, the
TVP is equal to the area 0ABL1.
So far we have analysed concepts
that help in understanding how an
increase in the employment of a factor
af fects the total revenues of a
competitive firm. Now we discuss how
it affects its costs. Suppose that the
factor L costs W per unit, i.e., the
hourly wage rate is Rs. W. Fig. 7.2
draws the Factor Price Line or the
wage line in this case. It is a horizontal
line since the wage rate is unaffected
by how many labour hours our
(a)
(b)
Fig. 7.1 The VMP Curve
competitive firm by definition, a small

firm hires in the labour market. The
point to note for us is that the area
under the factor price line is the total
factor cost or payment to the factor. If,
for instance, the firm hires L1 labour
hours, its total wage bill is the area
0WCL1.
Fig. 7.2 Factor Price Line
We are now ready to derive the

principle that governs how many
labour hours a profit-maximising firm
should hire. Turn to fig. 7.3, which
combines figs. 7.1(b) and 7.2. Let the
factor price facing the firm (wage rate)
be W0. The answer is that the firm
should hire up to that level, where the
factor price line intersects the VMP
curve, i.e. it should hire L0 labour
hours. In other words, the general
principle of hiring a factor (or profitmaximisation with respect to a
particular factor) is
(A) VMP of a Factor = Its Price.
Fig. 7.3 Factor Employment Decision
This condition is perfectly parallel

to the profit-maximising condition for
a competitive firm, that is P = MC.
Indeed the two conditions are two sides
of the same coin. The rationale behind
condition (A) is also parallel to that
behind P = MC. At L = L0 , TVP or total
revenue is equal to the area 0ACL0. The
total factor cost is equal to the area
1
127
0W0 CL0. Thus the gross profit, which

is the difference between TVP and total
factor cost, is equal to the area W0 AC.1
Now consider any employment level less
(such as LA) or more (such as LB) than
L0. We can compute that the profit is
less than W0 AC. For instance, at L = LA,
it is equal to W0 AFD, which is equal to
W0 AC CDF. At L = LB, it is equal to
W0 AC CEG. This proves that profit is
maximised at L = L0.
The law of diminishing returns is
the key. Starting from where the VMP
of a factor is equal to its price and
the MPP is diminishing, if the firm
hires one extra unit of the factor, the
VMP will be less than the factor price.
This is same as saying that the
additional revenue generated (equal
to VMP) is less than the additional
cost incurred (equal to the factor
price). This implies less profit than
before. Similarly, if the firm hires one
less unit than where VMP is equal to
the factor price, the VMP will be higher
than the factor price. As a result, the
revenue sacrificed (equal to VMP) by
hiring one unit less will be more than
the savings on the total factor cost
(equal to the factor price). Thus profit
will be less.
In summary, under diminishing
returns, any deviation from the
principle (A) will only generate less
profit. This proves why profit
is maximised when condition (A)
is met.
The adjective gross is attached, since fixed costs are not deducted. By definition, profit = gross
profit fixed cost. However, since the fixed costs are given, gross profit is maximised where profit is
maximised and vice versa.
128
Factor Demand Curve

Note from the preceding discussion that
a firm always chooses a point on the
VMP curve, and moreover, never at a
point where diminishing returns do not
hold. This means that the downward
portion of the VMP curve is the firms
demand curve for the factor.2 It also
means that a firms demand curve for a
factor is downward sloping.
Next we examine the determinants
or the sources of shift of the factor
demand curve.
7.1.3 Factor Demand Curve Shifts
Since the factor demand curve is a part
of the VMP curve, anything that shifts
the VMP curve shifts the factor
demand curve. We consider the
following sources of change.
A Change in Product Price
By definition, VMP = P.MPP. Hence an
increase in the product price, P,
increases the VMP at any given level of
factor employment. As a consequence,
the factor demand curve shifts to
the right (or up). This is illustrated
in fig. 7.4.
In general then, we can say that an
increase (a decrease) in the product
price shifts the factor demand curve
to the right (left).
From this result, we can see a link
between product and factor markets.
For instance, consider the industry of
a particular handicraft. On the
demand side, the product is sold in
2
Fig. 7.4 Product Price Increase and

Factor Demand
India and abroad. On the supply side,

there are artisans, who, with the help
of raw materials and equipment, make
the handicraft. Suppose that in an
international exhibition this handicraft
attracts a lot of attention. Many people
and organisations around the world
come to know about it and they like it.
Consequently there is an increase in
demand for this handicraft. From the
demand-supply analysis in Chapter 5
we know the effect: the price of this
handicraft increases.
Now consider the (factor) market
for artisans. The increase in the price
of the handicraft will shift their VMP
curve and hence the demand curve for
artisans to the right.
The general point here is that
factor demand is, in a sense, derived
from product demand. This is
why, factor demand is said to be a
derived demand.
This is parallel to the supply curve of a firm being same as the upward sloping portion of the marginal
cost curve.
(a) Technological Change increasing the

MPP of a Factor
129
such that the MPP of a factor increases,

then the demand curve for that
factor
shifts
to
the
right.
Fig. 7.5(a) shows this effect. Otherwise,
if the MPP of a factor decreases due to
a technological change, then its
demand curve shifts to the left.
Fig. 7.5(b) illustrates this.
For example, it is widely believed by
economists that, in recent two/three
decades, the whole world economy has
experienced technological progress that
has increased the MPP of skilled labour.
Whether it has increased the MPP of
unskilled labour is not clear.3
7.1.3 Marginal Productivity Theory
of Distribution
(b) Technological Change lowering the MPP

of a Factor
Fig. 7.5
Technological Change and

Factor Demand
Technological Change
A technological change can alter the
MPP of a factor and thereby its
demand curve, even when the
product price is unchanged. If it is
3
So far we have assumed that the firm

employs only one variable factor of
production. In reality, firms employ
many, e.g., different types of labour,
raw materials, power, various kinds
of machines, land etc. What are the
(profit maximising) principles that
govern the simultaneous demand/
employment of more than one factor?
They are simply the extensions of
the condition (A). If, for example, there
are two factors, say X and Y, their
respective prices are WX and WY, and
their respective marginal products are
MPPX and MPPY, the profit-maximising
principles are:
(A') VMPX = P.MPPX = WX ,
VMPY = P.MPPY = WY.
Another possible source of a shift in the factor demand curve, which we have not discussed and which
is something to be done in a higher course in microeconomics, is the change in the employment of
other factors.
130
That is, profit is maximised when

the VMP of each factor is equal to its
price.
Note that even when there is more
than one variable factor, the definition
of MPP remains valid.
Recall, from Chapter 1, the central
problem of for whom facing an
economy, which concerns who earns
how much. The conditions (A') imply a
theory of this, that is, each factor
ear ns the value of its marginal
physical product. It is called the
marginal productivity theory of
distribution.
This theory implies, for example,
that skilled workers normally earn
more than unskilled workers, because
the (marginal) productivity of skilled
workers is greater than that of
unskilled workers.
To see this more exactly, suppose
that factor X is skilled labour, factor Y
is unskilled labour, WX is the skilledlabour wage and WY is the unskilledlabour wage rate. Both work in the
same sector, and, let P be the price of
the good produced in that sector. Then
from (A),
WX
WY
P .MPPX
P .MPPY
MPPX
.
MPPY
Hence, if MPPX > MPPY, then WX >WY .

That is, skilled labour earns more than
unskilled labour.
4
7.2
TOTAL FACTOR DEMAND,

FACTOR
SUPPLY
AND
EQUILIBRIUM
In principle, factor prices should be

determined by forces of demand and
supply both, not just by demand forces
that we have emphasised so far.
However, when we do take into
account the supply side, the marginal
productivity theory does hold, with
appropriate interpretation. In order to
see this and analyse factor market
equilibrium in general, let us return
to the one-factor case.
We have derived a single firms
demand for a factor. There are many
fir ms in a per fectly competitive
industry. So, if we sum up the demand
for a factor across various firms, we
get the total industry demand curve
for that factor.4 However, some factors
are used in many industries and in
that case, the total demand curve for a
factor is the horizontal summation of
individual (firm) demand curves for
that factor in various industries
combined. In Fig. 7.6(a) and (b), the
total demand for a factor is shown as
the line DD. 5
We now turn to the supply side.
Consider, for example, teaching service
as a factor of production (in producing
education). If the salaries of school
teachers increase, more people than
before will be willing to choose school
The derivation of total demand for a factor is more complicated than the derivation of market demand
curve for a commodity. This complication arises due to a change in the price of the commodity when all
firms increase or decrease their outputs together. To simplify the discussion, the price of the commodity
is implicitly kept constant during this summing up.
How DD is derived is parallel to how the product market demand curve is derived from individual
demand curves.
teaching as a career. Hence the supply

curve of this factor service is upward
sloping. This is, however, true in the long
run. In the short run, like over a few
months or over a year, the supply of
school teachers in a particular region
will be given, because teachers
education, training and certification
etc. take years. This is true for almost
any type of (relatively high) skill. The
short run and long run factor supply
curves, denoted by SS, of a particular
skill are shown in panel (a) and panel
(b) of fig. 7.6 respectively.
The intersection of demand and
supply curves defines equilibrium in
the factor market similar to what
happens in a product market. In both
panels, E denotes the market
equilibrium point. The equilibrium
wage is denoted by W0, and N0 denotes
the equilibrium amount of the
particular skilled labour that is hired.
Besides different types of labour,
a firm hires land, capital etc. These
are examples of non-human factors of
production. Consider for instance the
supply of land. Here land does not just
mean a piece of land per se but
includes room, building floors etc. In
the short run the land supply is given.
In the long run it is likely to change.
The earning of land is the rent per unit
of space. Higher the rent, more land
or space will be supplied by landowners.6 Hence the long-run supply
curve of land is upward sloping also.
6
7
131
(a) Short Run
(b) Long Run

Fig. 7.6 Demand, Supply and Market
Equilibrium of a Particular Skill
Thus the land market equilibrium is

similar to that of a particular skill.
Fig. 7.6 applies except that rent
substitutes the wage rate and land
substitutes labour.
A point to note here is that, if we
interpret land narrowly in terms of
area on ground, the supply of land to
a particular industry is upward
sloping (in the long run), but land
supply to the entire economy is given.7
In the present context this is the price of land in terms of its service as a factor of production. It is
different from price of land as an asset.
There are exceptions. Countries like Japan and Hong Kong have claimed land from sea.
132
Capital is also a factor of

production. The term capital in
economics means different things in
different contexts. Here it means plants,
equipment, machinery etc. It is similar
to land in that it is non-human. We say
that capital earns rental. If you own an
Ambassador car and use it for taxi
business, then the hourly or daily rate
you charge is an example of capital
earning rental. It is dissimilar to
land in that the total capital stock in an
economy is reproducible, i.e. it can
be increased continuously over
time, whereas the total land space is
non-reproducible. In any event, fig. 7.6
applies to the market for a particular
type of capital.
There are two general implications
of our factor demand-supply analysis.
A. An increase in demand for a factor
tends to increase its price (by
shifting out its demand curve) and
an increase in the supply of a factor
tends to lower its price (by shifting
out its supply curve). By now this
conclusion must be something very
evident to you. It can be applied to
various sources of shifts and their
effect on factor price. For instance,
if there is an increase in the
demand for a commodity, the
production of which requires a
specific skill (e.g. computer skills),
the wage of this skill (e.g. of
computer engineers) will increase.
A technological change that
improves the MPP of a factor will
enhance its reward.
B. Whichever factor is under
consideration, at the equilibrium
point, from the demand side, the

factor reward is equal to the value
of its marginal physical product.
Thus the marginal productivity
theory holds when the marginal
physical product is evaluated at
the equilibrium quantity of the
factor service that is in use.
7.3
TRADE UNIONS
The demand-supply analysis above

refers to how the price/market
mechanism
works
in
factor
markets. This is parallel to our demandsupply analysis for commodities in
Chapter 5. In that chapter we also saw
that the government sometimes directly
intervenes in a market and fixes the
price of a product in the form of control
price and support price.
In the factor market, there is also
an important example where a factor
price is not determined by the market.
You might have heard of workers
organisation in various sectors of the
economy called trade unions or labour
unions. These unions voice grievances
of workers in a collective way.
Sometimes they organise strikes and
boycott work for days and weeks. Very
often they also try to bargain for higher
wages than the employers are willing
to offer. Sometimes they succeed in
negotiating a wage rate, which is higher
than what the equilibrium wage rate
would have been in the labour market.
What effect does this wage-fixing
by trade unions have on the labour
market? Turn to fig. 7.7, where Ls
denote the total number of workers.
This is the supply curve of labour. The
133
demand curve for labour is denoted by

LD. If there were no trade unions, the
intersection of the labour supply and
labour demand curves would have
determined the market wage rate. In the
diagram, W0 would have been market
wage. Now suppose that the trade
union fixes the wage at W1, which is
higher than W0. As a result, the firms
will demand less labour, which is
indicated at the point D1 on the labour
demand curve, or equivalently, at the
point L1 on the horizontal axis. What
we see now is that there is
unemployment of labour; L 1 L s
measures the number of workers who
are unemployed.
Fig. 7.7 Trade Unions and Unemployment
Thus, unemployment sometimes

may be caused by the presence of trade
unions.
SUMMARY
l
A factor service is demanded by firms and supplied by households.
Factor price is determined by forces of demand and supply of a factor.
For a competitive firm, the VMP curve of a factor is generally inverse

U-shaped. This is because of the law of diminishing returns.
For a competitive firm, TVP of a factor is equal to the area under its VMP
curve.
The total factor cost or payment to a factor is the area under the factor
price line.
For a competitive firm, profit maximisation occurs when each factor is

paid its VMP.
The demand curve for a factor is essentially the downward sloping portion
of its VMP curve.
An increase in the product price shifts out the demand curve of a factor.
In this sense, the demand for a factor is derived demand.
134
l
l
l
l
l
l
l
l
The MPP of a factor and hence its demand curve can shift because of
technological changes.
Marginal productivity theory implies that different factors are paid
differently because of differences in their VMPs.
Skilled labour is paid more than unskilled labour because the marginal
product of former is higher than that of the latter.
The total demand curve for a factor is the horizontal summation of
individual (firm) demand curves for that factor.
The supply curve of a factor is upward sloping in the long run, but it may
be vertical in the short run.
Capital, as a factor of production, is different from land in the sense that,
unlike land, it is typically reproducible.
An increase in the demand for a factor tends to increase its price, while an
increase in the supply of a factor tends to lower its price.
When a labour union fixes a wage above the market-clearing wage,
unemployment results in the labour market. It is because, at a higher
wage rate, firms employ less labour, while the supply of labour by workers
may increase or remain unchanged.
EXERCISES
Section I
7.1
7.2
7.3
7.4
7.5
7.6
7.7
7.8
7.9
7.10
7.11
7.12
7.13
Who are the demanders in the factor markets?

Who are the suppliers in the factor markets?
To which central problem does the problem of factor pricing relate
to?
How are TVP and TPP of a factor related?
How are VMP and MPP of a factor related?
What is the difference between MPP and VMP of a factor?
How is the TVP of a factor derived from its VMP curve?
What happens to TVP of a factor when its VMP is positive?
What happens to TVP of a factor when its VMP is negative?
How is the total payment to a factor derived from the factor price
line?
What is the relationship between the VMP curve and the factor
demand curve?
Name two factors responsible for a shift in the factor demand curve.
What is the relationship between the wage rate that a labour union
typically fixes and the equilibrium wage rate?
135
Section II
7.14
7.15
7.16
7.17
7.18
7.19
7.20
7.21
7.22
The TVP at the employment level L = 4 is 50 units. That at L = 5

is 65 units. The price of the product is Rs. 3. What is the MPP at
L = 5?
The product price is Rs. 5. The TPP schedule of a factor is given
in the following table. Derive its VMP schedule.
Employment of a Factor
TPP (units)
20
32
42
50
56
60
62
The total payment to a factor is Rs. 12,000. The price of the

factor is Rs. 40. How many units of that factor are being
employed?
Suppose that the product price is Rs. 10 and a factor is paid
Rs. 70 per unit. The law of diminishing returns holds. At some
level of employment, MPP = 5. Show that, at this level of
employment, profit is not being maximised. Should the firm
increase or decrease employment in order to increase its
profits?
Explain why a factor demand is called derived demand.
What does the marginal productivity theory of distribution say
about the earnings of different factors?
Explain why skilled workers earn more than unskilled workers.
How does an increase in the supply of a factor affect its earning
(price)?
Unfortunately an earthquake hits a town and destroys many
residential flats, which were used for renting. All other things
136
7.23
remaining unchanged, will this affect the demand curve or the

supply curve of residential flats for rent and how? How will it
affect the rental rate per month?
Suppose that technological advance takes place in such a way
that the MPP of skilled labour increases. How will it affect the
wage of skilled labour? Further suppose that the technology
advance lowers the MPP of unskilled labour. How will it affect
the wage of unskilled labour?
Section III
7.24
7.25
Explain how profit is maximised when the VMP of a factor is

equal to its price.
Explain why, under perfect competition, the VMP curve for an
input is considered its demand curve.
COMPARATIVE ADVANTAGE, INTERNATIONAL TRADE
CHAPTER
AND
FACTOR MOBILITY
137
COMPARATIVE ADVANTAGE, INTERNATIONAL

TRADE AND FACTOR MOBILITY
8.1 Ricardo's Theory of
Comparative Advantage
and Benefit from Trade
8.2 Factor Endowment

Theory of International
Trade
8.3 Factor Mobility
In previous chapters we studied how

producers and households interact with each
other in product and factor markets. We can
think of such interaction as trade between
producers and households, in the sense that
each party has something to offer to the
other. Not only producers and consumers
within a country trade with each other, the
countries themselves, i.e., consumers and
producers across countries, trade/exchange
with each other in goods and services. This
is called international trade. As an example
of trade in goods, India exports tea to the
rest of the world and imports petrol. Many
foreign banks today offer banking services
in India, which is an example of trade in
services.
In this chapter, our objective is to learn
some fundamentals of international trade.
This is very important, because countries, in
general, are much more interdependent today
than they were 30 or 40 years ago.
In the process, we learn a very important
concept in economics, called comparative
advantage. Through this concept, we will
understand that promoting international
trade is not a bad thing, and, it is not true
that, if one country gains from it, some other
country has to lose. On the contrary, we will
138
learn that trading with each other is,

by and large, a mutually beneficial
activity.
The idea behind comparative
advantage (to be defined in Section 8.1)
and gains from trade can be
understood through this example.
Suppose that you are a very good pop
singer and a very good cook. But you
are much more productive as a singer
than as a cook. This is in the sense
that if you sing you get Rs. 5,000 per
hour, whereas you can hire an
excellent cook at the rate of Rs. 300
per hour, i.e., if you cook, you save
Rs. 300 per hour. One option for you
will be to pursue a singing career and
still cook for yourself be selfsufficient, so-to-speak. That is, you
are capable of doing both and you
actually choose to do both. Consider
now the alternative option of hiring a
cook and engaging yourself full time
in singing. Which option will you
prefer? Surely, the latter. Now think
about this example in a different light.
The option to do both activities is like
choosing not to do trade between your
service as a cook and your service as
a singer. The latter option is like
importing the service that you do not
have comparative advantage in (that
is, cooking) and, specialising and
exporting the service you have
comparative advantage in (that is,
singing).
What applies for an individual in
the above example also applies to a
country. A country, in comparison
to producing all goods it can produce
and not trading, is better off by
(a) producing more of the goods which

it can produce relatively cheaply and
exporting part of them and (b)
producing less possibly none of the
goods which it cannot produce
relatively cheaply compared to other
countries and importing them. This is
the idea behind comparative
advantage. Put differently, it implies
that countries can trade and benefit
by exploiting their differences. In
simpler language, it means that you
and I are different, I have something
which you want but cannot obtain that
easily, and you have something that I
want but cannot get that easily;
both are better off by trading with
each other.
This
principle
was
first
demonstrated formally by a famous
English economist, named David
Ricardo. In what follows, we first
discuss
Ricardos
theory
of
comparative advantage. It is the
simplest and yet a very elegant
exposition of how international trade
can be beneficial to a country.
Although Ricardo wrote about it
almost two hundred years ago (in the
early 19th century), its relevance is felt
even today.
As we will see, Ricardos theory of
comparative advantage and trade is
based on differences in technology
across countries. We also consider
another source (basis) of comparative
advantage, namely, differences in
factor supplies across countries. The
next two sections study these
alternative sources of comparative
advantage.
International trade refers to

movement of goods and services. In the
real world, not only goods and services,
but also factors of production move
from one place to another. The chapter
ends with a discussion of movement
of factors.
8.1
RICARDOS THEORY OF
COMPARATIVE ADVANTAGE
AND BENEFIT FROM TRADE
We will make a number of simplifying

assumptions so as to clearly bring out
the essence of this theory. Assume that
there are two countries in the world:
India (N) and Australia (A). Each can
produce two goods, say, cricket bats
and footballs. Perfect competition
prevails in the market for each good.
There is one factor of production, say,
labour (L). Each country is endowed
with a given supply or what is called
endowment of labour, say LN = 100
and LA = 120 respectively for India and
Australia. Furthermore, the labour
required to produce one unit of output,
or what is called the labour coefficient,
is given in each sector. As a numerical
example, suppose that
Producing 1 cricket bat in India
requires 10 units of labour
Producing 1 football in India
Producing 1 cricket bat in Australia
requires 15 units of labour.
Producing 1 football in Australia
1
AND
FACTOR MOBILITY
139
This is written more compactly in

Table 8.1.
Table 8.1 Labour Coefficients
India
Australia
Cricket Bats
10
15
Footballs
20
60
In terms of concepts introduced in

Chapter 3, the average physical
product of labour is the inverse of the
labour coefficient. Thus, labour
coefficient being given means constant
average physical product of labour or
constant output per worker.1
We are almost ready to define
comparative advantage.
8.1.1 Absolute Advantage and
Comparative Advantage
Between two countries, one is said to
have absolute advantage in a good if
it can produce that good absolutely
more efficiently than the other country.
A country is said to have comparative
advantage in a good if it can produce
it relatively more efficiently or relatively
less inefficiently, compared to the
other country.
We now apply these definitions to
Table 8.1 and say that India has
absolute advantage in producing both
goods, and Australia in none. Because,
in the production of either good, labour
required to produce one unit is less
in India than in Australia. More
importantly for us, let us determine who
In turn, this means constant marginal physical product of labour.
140
has comparative advantage in what.

See that, in India, the labour coefficient
ratio of the football sector to the cricket
sector is 20/10 = 2, whereas, in
Australia, the same ratio is 60/15 = 4.
Hence, in India, labour is relatively more
productive or efficient in the football
sector. Therefore, India, has
comparative advantage in producing
footballs. Although Australia is less
efficient in producing both goods, it is
relatively less so in producing cricket
bat. Hence Australia has comparative
advantage in producing cricket bats.
By definition, both countries cannot
have comparative advantage in
producing the same good.
8.1.2 Production Possibility Curves
Given the labour coefficients and the
labour endowment in each country, we
can draw the Production Possibility
Curve (PPC) for each country. This will
serve as a background to analysing
how international trade affects an
economy.
Recall from Chapter 1 the concept
of marginal opportunity cost along a
PPC. It says how much of one good has
to be sacrificed to ensure a unit
increase in the production of the other.
Consider India for instance. Suppose,
starting from a given allocation of
labour between the football sector and
the cricket bat sector, the production
of football increases by one unit. From
Table 8.1, this requires additional
labour equal to 20 (since this is labour
coeffcient in producing football). As 20
units of labour leave the cricket bats
sector to produce one extra football, by
how much will the production of cricket

bats fall? It is equal to 20 divided by
the labour coefficient in producing
cricket bats (that is, 10). This gives
20/10 = 2 cricket bats as the marginal
opportunity cost of football.
Note that the marginal opportunity
cost of football is constant (equal to 2
cricket bats) at any initial allocation
of resources, because the labour
coefficients are constant. You can
similarly calculate that cost in
Australia, which is also constant,
equal to 60/15 = 4. Thus labour
coefficients being given imply that the
marginal opportunity cost of either
good along the PPC is constant. In turn,
from Chapter 1, we know that constant
marginal opportunity cost implies a
straight line PPC. Hence the PPC is a
straight line in a Ricardian economy.
Fig. 8.1 shows the PPCs of India and
Australia. Recall that Indias
endowment of labour is 100, i.e.,
LN =100. If all its labour resources are
used in producing football, they will
produce 100/20 = 5 footballs. If,
instead, they are all used in producing
cricket bats, they will produce
100/10 = 10. These points are
respectively marked on the football axis
and cricket bat axis in fig. 8.1(a). The
straight line, DE, joining these two
points is the PPC of India. The PPC of
Australia, GH, is derived in a similar
manner, which is shown in fig. 8.1(b).
8.1.3
No Trade
In order to see how international trade

makes a difference, suppose that
initially there is no trade between the
(a) India
AND
FACTOR MOBILITY
141
(b) Australia
Fig. 8.1 The Production Possibility Curves
two countries. There are four important

points to note for the world economy,
in which there is no trade.
1. Since there is no opportunity to
trade, in each country, the
consumption of a good cannot
exceed how much of that good is
produced. In other words, the
consumption possibilities are
limited to the PPC, i.e., the country
cannot consume at any point
outside its PPC. We can say that
the PPC is equal to a countrys
consumption possibility curve. In
our example, it is DE for India and
GH for Australia.
2. It will also be useful to know the
relative price of one good in terms
of the other in each country. What
do we mean? Recall that both
goods are produced in competitive
markets. From Chapter 6, we know
that, under perfect competition,
free entry and exit imply zero profits.
Thus, in each sector, price will be

equal to the average cost. In this
economy, the average cost of a good
is equal to the wage rate times the
labour required to produce one unit
of the good. For example, let WN be
the wage rate in India. Then the
average cost of, say, football is Rs.
WN 20. This will be equal to the
price of football, say PF. Similarly, PC
= Rs. WN 10, where PC is the price
of cricket bats. Thus the relative
price of football is equal to PF/PC =
WN 20/(WN 10) = 2. That is, if
you have a football, sell it in the
market and use the money to buy
cricket bats, you will get 2 cricket
bats. The relative price of cricket
bats is the inverse of that of
football, equal to 1/2. In general,
the relative price of a good is
defined in terms of some other good
and is equal to the amount of the
142
other good that one gets in

exchange for one unit of the good
in question. Put differently, it is an
exchange ratio between goods. We
then have the exchange ratio in
India in the no-trade situation
equal to
2 cricket bats for 1 football.
You can similarly calculate the
exchange ratio in Australia:
4 cricket bats for 1 football.
We can call these the domestic
exchange ratios.
3. Notice that the relative price of a
good in each country is equal to
its marginal opportunity cost (as
price is equal to marginal cost
under competitive conditions). In
Australia for example, the
relative price of football is 4
cricket bats and the marginal
opportunity cost of football is
also 4 cricket bats.
4. Also notice from the exchange
ratios that football is relatively
cheaper in India, which has
comparative
advantage
in
producing football, and cricket
bats are relatively cheaper in
Australia, which has comparative
advantage in producing cricket
bats. This is intuitive.
The stage is ready now to
understand the effect of international
trade.
8.1.4 Effect of International Trade
Let India and Australia now open up
trade. Further, let there be free trade,
i.e., no restrictions like trade taxes or
any limits on how much a country can
export or import etc. Also, assume

that there is no transport cost of
moving goods between the two
countries. (We make these strong
assumptions, not because they are
critical for our argument, but because
they help us to see the effect of trade
very clearly.)
The above assumptions imply that
the exchange ratios or the relative price
of a good will be the same in the two
countries. It is because, if a good is
cheaper in one country than in the
other, every one in both countries will
buy the product from the former
country and this will push its price up.
In equilibrium, the exchange ratios will
be the same. We can call this the world
exchange ratio or what is called the
world terms of trade.
Range of World Terms of Trade
The next question is: what will be the
equilibrium world terms of trade?
Terms of trade, in general, refer to a
relative price and we know from
Chapter 5 that the equilibrium price
of a good is determined by supply and
demand forces. The supply side of an
economy is represented by the PPC of
a country. But we do not have any
information on the demand side.
Hence, we cannot determine the world
terms of trade exactly.
We can, however, find its range: it
will lie in between the domestic
exchange ratios. In this example, it
means that the world relative price of
football will be in between 2 and 4
cricket bats. It cannot exceed 4 or fall
short 2. Why? Suppose it exceeds 4, say
AND
FACTOR MOBILITY
143
1 football for 5 cricket bats. Then, in

both countries, a football fetches more
than it fetches in the no-trade situation
and thus both would like to export
football. But this is not possible, since
there is no third country they can both
export to: by definition, the two
countries comprise the world economy.
(When there are more than two
countries, you can group them into the
home country and the rest of the
world and the same argument holds.)
You can similarly argue that if the world
terms of trade are 1 football for
something less than 2 cricket bats, both
countries would want to import football
and that is not possible. This proves
that the equilibrium world terms of
trade will lie between the domestic
exchange ratios. Assume that the world
terms of trade lie strictly in between
the two domestic exchange ratios. As
an example, suppose that they are
equal to
1 football for 3 cricket bats.
football only. Mark that football is the

good, in the production of which India
has comparative advantage. By similar
argument, Australia specialises in
cricket bats, in which it has
comparative advantage. Specialisation
occurs as the world terms of trade are
different from the domestic exchange
ratio. This is shown in fig. 8.2, which
graphs the same PPCs as in fig. 8.1
(shown by the dashed lines). Indias
and Australias production points in
free trade are shown at points D and
H respectively.
We can then summarise that in the
Ricardian world economy, as long as
the world terms of trade differ from the
domestic exchange ratio, a trading
country specialises in the good, in the
production of which it has comparative
advantage. This is how international
trade affects production and resource
allocation in an economy.
Specialisation
Now we come to the last stage of our

discussion. What are the consumption
possibilities facing the two countries
and how do they benefit from trade? But
before we address this question, we
should know what we mean by exports
and imports. Exports of a commodity
are equal to its production minus its
consumption, whereas imports of a
commodity are equal to its
consumption minus its production. In
other words, if a good is exported
(imported), then its production exceeds
(falls short of) its consumption in the
country.
Now think about how much of each

good will be produced in the two
countries. From the viewpoint of India,
the relative price of football is 3 cricket
bats, which is greater than its the
marginal opportunity cost (equal to 2
cricket bats). This will mean that there
are abnormal profits in the football
sector. Hence resources (labour) will
move out of the cricket bat sector to
the football sector. This process will
continue until there is no production
of cricket bats in India. That is, India
specialises in football, i.e. produces
Consumption Possibilities
144
(a) India
Fig. 8.2
Free International Trade in the Ricardian Economy
In fig. 8.2, since India produces at

D, one consumption possibility for her
is the point D itself. But there are other
possibilities. For instance, it can export
one football in exchange for 3 cricket
bats (all imported), or 2 footballs in
exchange for 6 cricket bats (all
imported) and so on. These
possibilities give rise to the heavy line
DE', whose slope is 3, equal to the
relative price of football in the world
market. 2 Put differently, the
consumption possibility curve for India
at the world terms of trade, equal to 1
football for 3 cricket bats, is the heavy
line DE'. This situation is surely a
better proposition for India than no
trade, which only offered the
consumption possibilities along the PPC
(b) Australia
that lies to the left of or inside the line

DE'. Alternatively, you can see that for
every possible consumption point in the
no-trade situation, e.g., A, except the
corner points on the PPC, there is at least
one point on DE', which guarantees
more consumption of each good. Hence,
free trade must be preferred to no trade.
By similar argument, Australias
consumption possibility curve is now
the heavy line G'H, whose slope is also
equal to 3, the relative price of football
in the world market. The line G'H lies
outside Australias PPC. Thus
Australia also benefits from free trade.
Note that, irrespective of which
consumption points on DE' and G'H are
chosen, India exports footballs and
Australia exports cricket bats. That is,
The concept of slope of a straight line is explained in Appendix 2.
each country exports the good it

has comparative advantage in. This
is a very general principle of
international trade.
The lesson to be learnt from the
Ricardian theory is that a country
benefits from international trade by
specialising and exporting the
products that it has comparative
advantage in. This is true even when
a country is more efficient in
producing all goods in an absolute
sense.
8.2 FACTOR ENDOWMENT THEORY
OF INTERNATIONAL TRADE
In the Ricardian theory, it is the
difference in technology that forms
the basis of comparative advantage
and mutually beneficial trade.
Otherwise, if the ratio of labour
coefficients is the same between the
two countries, then the domestic
exchange ratios will be the same; no
country will have comparative
advantage in producing any good
and there will be no reason to trade.
Even if international trade is opened
between the two countries, nothing
will change in any country.
However, technology differences are
not only basis for comparative
advantage and trade. Differences in
relative factor endowment (to be defined
in a moment) form another major basis
for comparative advantage. The theory
3
4
AND
FACTOR MOBILITY
145
that brings out this point is called the

factor endowment theory.3
View the world as having two
countries once again, say, India (N) and
America (A). They produce two goods:
Chairs (C) and Medicine (M). Instead of
one factor of production, suppose that
there are two, labour and capital. They
are required in producing each of these
two goods. There are constant returns
to scale. Furthermore, the technology
of producing either good is same
between India and America and the
production of chairs is relatively labourintensive and that of medicine is
relatively capital-intensive.4 All markets
are perfectly competitive.
Suppose that the supply of each
factor in each country is given. We can
call these factor endowments, just like
labour endowment in the Ricardian
theory.
8.2.1 Factor Endowment Difference
Let LN and KN denote the endowments
of labour and capital in India.
Likewise, let L A and KA denote the
endowments of labour and capital in
America. These are absolute factor
endowments. The ratio of absolute
endowments is called the relative
factor endowment. For example,
LN/KN is the relative endowment of
labour in India.
Having defined relative endowment,
we can always compare it between
countries. In our example, we say that
It was formulated originally by two Swedish economists, Eli Heckscher and Bertil Ohlin, and is
called the Heckscher-Ohlin theory.
It is not that the technology cannot differ between countries. But the idea here is to suppress such
difference and focus on difference in factor endowments.
146
India is the relatively labour-abundant

country and America is the relatively
capital-abundant country, if
( A)
LN
KN
LA
.5
KA
Let us assume this, since it is

reasonable to suppose that India is a
relatively labour-abundant country,
compared to America.
8.2.2 Factor Price Difference
What does this difference in relative
factor endowment imply for factor
prices? We first define two terms:
absolute factor price difference and
relative factor price difference. In
general, we say that there is an
absolute factor price dif ference
between two regions or countries if the
reward (price) of a factor dif fers
between the two regions or countries
in absolute terms. For instance, if
labour earns wage equal to Rs. 50 per
day in India and Rs. 200 per day in
America, we say that there is an
absolute wage difference and the wage
rate is less in India than in America.
Similarly, there can be an absolute
difference in the rental rate of capital
between the two countries.
Given our ranking of the relative
endowment in (A), can we say anything
about absolute factor price differences
between India and America? The
answer is no, because the ranking (A)
does not say anything about absolute
endowment levels. But it can say
5
something about relative factor price

difference, where relative factor price is
defined as the ratio of factor rewards.
Suppose that, in America, labour
earns wage equal to Rs. 200 and capital
earn rental equal to Rs. 1,000. In India,
let the wage rate and the rental to
capital be Rs. 100 and Rs. 900
respectively. Thus, the two absolute
factor rewards are less in India. But,
relatively speaking, the wage/rental
ratio is greater in America. It is 1/5 there
and 1/9 in India. In this case, we say
that relative reward (price) of labour is
greater in America and the relative
reward of capital is greater in India.
Indeed, our relative factor ranking (A)
implies this. How?
Our analysis of factor price
determination in Chapter 7 comes into
play. Let us invoke a result from that
chapter which states that, greater the
supply of a factor, the lower is its reward.
In the present context, it implies that,
since India (respectively America) is
relatively labour (respectively capital)
abundant, the wage/rental ratio in India
will be less than that in America. In
other words, India is the relatively lowwage country and America is the
relatively high-wage country.
8.2.3 Comparative Advantage
We now proceed to analyse how the
dif ference in the relative factor
endowment and the resulting
difference in the relative factor price
determine the flow of goods between the
For example, let LN = 1, 500, KN = 500, LA=2,000 and KA = 1000. Then LN/KN = 3, LA/KA = 2, and thus
L N/K N>L A/K A.
two countries. Ask yourself which good

will be produced more efficiently (i.e.
with lower cost) in the low wage/rental
ratio country and in the high wage/
rental ratio country. Remember that the
production technology of chairs (C) is
labour-intensive and that of medicines
(M) is capital-intensive. The answer is
that the labour-intensive good C will be
produced relatively more efficiently in
the relatively low-wage, labour abundant country, and, the capitalintensive good (M) will be produced
relatively more efficiently in the relatively
high-wage, capital-abundant country.
We can state this in terms of
comparative advantage. The relatively
labour-abundant, low wage/rental
ratio, country (India) will have
comparative advantage in producing
the relatively labour-intensive good.
The relatively capital-abundant, high
wage/rental ratio country (America)
will have comparative advantage in
producing the relatively capitalintensive good.
8.2.4
International Trade
Thus far we have linked relative factor

endowment difference and relative
factor price difference to comparative
advantage. We next link comparative
advantage to international trade:
i.e.,compared to no trade, in free trade,
a country will produce more and
export the product, in which it has
Joining the two links now, we can
say that the relatively labour-abundant,
low wage/rental ratio, country (India)
will export the relatively labour-
AND
FACTOR MOBILITY
147
intensive good (chair) and the

relatively capital-abundant, high
wage/rental ratio, country (America)
will export the relatively capitalintensive good (medicine). This is how
the relative factor endowment difference
and the relative factor price difference
are linked to international trade.
You can reflect back to see that the
aforementioned result is quite
reasonable. This is the gist of the factor
endowment theory. It emphasises
relative factor endowment difference
as the basis of comparative
advantage and predicts that a country
will export those products which uses
its relatively abundant factor more
intensively.
Three remarks are in order.
1. Unlike the material in previous
chapters and our discussion of the
Ricardian theory, the factor
endowment theory has been
merely sketched. A specialised
course in international economics
will deal with this theory in more
detail.
2. In Chapter 7, we learnt that the
demand for a factor is called a
derived demand. This is because
changes in product markets affect
the demand for a factor. In
contrast, the factor endowment
theory illustrates how factor market
differences influence the product
market the pattern of flow of goods
between countries. Thus, a general
and an important point to be learnt
is that, in an economy, factor and
product markets are very much
interrelated.
148
3. Recall the central prediction of the

factor endowment theory. In our
example, India, the relatively
labour-abundant country, exports
relatively labour-intensive goods
and America, the relatively capitalabundant
country
exports
relatively capital-intensive goods.
We can look at this conclusion in a
different light. India exporting
relatively labour-intensive goods
can be thought of as India
exporting the services of labour.
Likewise, America exporting
relatively capital-intensive goods
means that America is exporting
capital services. Put differently,
international trade in goods can be
seen as international trade in factor
services. This again shows how
interrelated goods and factor
markets are; it is as if factors are
moving internationally, although
they are not (in our analysis).
8.3 FACTOR MOBILITY
The very last point made brings us to
the very last topic to be analysed in
this book. That is, factors do move
between regions and countries. In our
country daily labour moves typically
from villages to towns. There are
thousands of workers from India who
are working in middle-east countries
like Kuwait and Yemen.
These are not the only instances
of mobility. Unskilled labour moves
from Mexico to America. Skilled
workers move typically from countries
like India and China to Europe and
America.
We now ask why factors move the

way they do? Here, unlike in the factor
endowment theory, the absolute factor
price difference (already defined) plays
a role. As an example, we have already
noticed that in India daily labour
moves from rural to urban areas. Why
is this so? Because, there is an
absolute factor price difference. Given
such a difference, a factor moves from
the low-reward region to a high-reward
region. Daily labour earns more in an
urban area on an average than in a
rural area on an average. This induces
it to move from rural to urban areas.
However, the absolute factor price
difference or in this case the ruralurban wage differential, is just an
immediate cause of factor/labour
migration, not the underlying cause.
This chapter and the book ends
with an investigation of why a ruralurban wage differential exists.
We can think of this issue in terms
of demand and supply of a factor,
studied in Chapter 7. Indeed there are
differences in both demand and supply
sides, which explain the rural-urban
difference in daily wage.
First, there are more nucleus
families, as opposed to joint families,
in urban areas than in rural areas. In
many urban households, both
husband and wife work outside the
home. Hence there is a greater demand
for household services like cleaning,
cooking etc. Also, construction works
are more prevalent in urban than in
rural areas. Both these factors imply
higher demand for daily labour in
urban areas, compared to rural areas.
Second, the urban cost of living is

higher than the rural cost of living, so
that families of many daily workers
prefer to live in rural areas. This
implies that, ceteris paribus, the
supply of daily labour in towns is less
than in villages.
Both these factors together imply
that the urban wage must be higher.
We can see this in terms of fig. 8.3.
There are two demand curves. The one
to the right, DDB, can be interpreted
as the demand curve for daily labour
in the urban area and the one to the
left, DDR, can be thought of as that in
the rural area. There are also two
supply curves. The one to the left, SSB,
marks the supply curve in the urban
area and the one to the right, SSR,
marks that in the rural area. The
urban labour market equilibrium is
shown at the point EB where DDB and
SSB intersect. Likewise, the labour
market equilibrium in the rural area
occurs at the point ER where the curves
DDR and SSR intersect. As we can see
clearly, the urban wage, WB is greater
than the rural wage, WR.
Once we establish that there is an
absolute difference in wages, it is easy
to predict that labour wants to move
from a low-wage region to a high-wage
region.
AND
FACTOR MOBILITY
149
Fig. 8.3 Urban and Rural Wage for Daily

Labour
We note that this is true not just for

unskilled labour but also for skilled
labour. Skilled workers want to move
out of countries like India and China
to the U.S. and Europe in order to earn
higher wage for their skill. Similarly,
capital, which earns less rental in
capital-abundant developed countries,
has an incentive to move (through
multinational firms) to capital-poor,
high-rental, developing countries.
We should carefully note however
that absolute factor price difference is
only an immediate cause or an
indicator of factor movement.
Regional differences or differences
between countries in demand and
supply conditions of factors are the
underlying
cause
of
factor
movement.
SUMMARY
l
l
l
The principle of comparative advantage implies that countries can benefit

from trade by exploiting their differences.
In the Ricardian theory, differences in technology form the basis of
Average physical product a factor is the inverse of its coefficient.
150
l
l
l
l
l
l
l
l
l
In the Ricardian economy, constant labour coefficients imply that the

marginal opportunity cost of a good, in terms of the other along the PPC,
is constant. This in turn implies that the PPC is a straight line.
In the absence of trade, a countrys PPC is same as its consumption
possibility curve.
The world terms of trade lie in between the domestic exchange ratios.
In the Ricardian economy, a country specialises, in free trade, in the good
in which it has comparative advantage, as long as the world terms of
trade are different from the domestic exchange ratio.
In the Ricardian economy, as long as the world terms of trade are different
from the domestic exchange ratio, the consumption possibility curve in
free trade lies outside its PPC.
The Ricardian theory illustrates that a country benefits from international
trade by specialising and exporting the products that it has comparative
advantage in. This is true even when a country is more efficient in
producing all goods in an absolute sense.
The differences in relative factor endowment also form a basis of
comparative advantage. This is captured by the factor endowment theory.
A difference in the relative factor endowment causes a difference in the
relative factor price.
A relatively labour (capital) abundant country will have comparative
advantage in relatively labour (capital) intensive goods.
Factor endowment theory of trade predicts that a country will export the
products which use its relatively abundant factor more intensively.
This prediction can also be interpreted as that a country exports the
services of its relatively abundant factor and imports the services of its
relatively scarce factor.
Absolute factor price difference is the immediate cause, not the underlying
cause, of factor mobility. In turn, absolute factor price difference arises
because of variations in demand and supply factors in respective regions.
Compared to rural areas, in urban areas, the daily wage rate is higher.
This is because of greater demand for daily labour and less supply of
daily labour in the urban areas.
The greater demand for daily labour in urban areas stems from higher
demand for household work and construction projects. Higher cost of
living in urban areas implies less supply of daily labour in these areas, as
families of many daily workers prefer to live in rural areas.
AND
FACTOR MOBILITY
EXERCISES
Section I
8.1
8.2
8.3
8.4
8.5
8.6
8.7
8.8
8.9
8.10
8.11
8.12
8.13
What is meant by international trade?

Give one example of international trade in services.
What is meant by labour coefficient?
Give the meaning of absolute advantage.
Give the meaning of comparative advantage.
What does the Ricardian theory emphasise as a basis of
comparative advantage?
In the Ricardian theory, which good does a country specialise
in free trade?
In the no-trade situation, what is the relationship between a
countrys PPC and its consumption possibility curve?
In the Ricardian theory, in the free-trade situation, what is the
relationship between a countrys PPC and its consumption
possibility curve?
What does the factor endowment theory emphasise as a basis
of comparative advantage?
What is meant by relative factor endowment difference?
What is meant by relative factor price difference?
What is meant by absolute factor price difference?
Section II
8.14
8.15
8.16
8.17
8.18
8.19
Give two examples of international trade in services.

Explain the concept of comparative advantage by using a
suitable example.
Explain that, in a two-country Ricardian world economy, both
countries cannot have comparative advantage in producing the
same good.
Explain how, in the Ricardian world economy, constant labour
coefficients imply that the PPC is a straight line.
In an economy, there is one factor of production, labour. Two
goods are produced: sitar and guitar. 5 units of labour is
required to produce one sitar and 12 units of labour is required
to produce one guitar. Determine the domestic exchange ratio
between sitars and guitars in this country.
The following table gives labour coefficients in the two sectors
in two countries. Determine which country has absolute
advantage and comparative advantage in which good.
151
152
8.20
8.21
8.22
8.23
8.24
8.25
8.26
8.27
8.28
8.29
8.30
8.31
Popland
Rockland
Sitar
50
60
Guitar
60
50
Refer to the previous question. Suppose technological progress

occurs in Popland. As a result, the labour coefficients are now
40 and 30 respectively for the sitar sector and the guitar sector.
Determine which country now has absolute and comparative
advantage in which good.
A Ricardian economy can produce two goods: tooth brush and
shoe brush. The labour coefficients in these two sectors are
respectively 30 and 90. Its labour endowment is equal to 1,800.
If the world terms of trade facing this country are 1 tooth brush
for 4 shoe brushes, determine how many tooth brushes and
shoe brushes this country will produce in free trade.
Differentiate (with example) between a capital-intensive good
and a labour-intensive good.
Explain absolute factor price difference. Why may it arise?
Explain relative factor price difference. Why may it arise?
Name two commodities which are relatively labour-intensive in
production.
Name two commodities which are relatively capital-intensive in
production.
Name two relatively labour-abundant countries.
Name two relatively capital-abundant countries.
The world consists of two countries: Blueland and Yellowland.
There are two factors, labour and land. They produce two
goods, apples and grapes. The production of apples is relatively
more land intensive compared to grapes. Suppose the
endowments in the two countries are as given in the following
table. If both countries engage in free trade with each other,
determine which country will export what.
Blueland
Yellowland
Labour
50
60
Land
70
140
Give two instances where factors are mobile.

Name two labour-intensive commodities in India.
8.32
AND
FACTOR MOBILITY
Suppose the supply of workers for household services declines

in the economy. How will it affect the urban and rural wage for
these services?
Section III
8.33
8.34
8.35
Explain why a relatively labour-abundant country will export

relatively labour-intensive goods.
Analyse why daily wage is higher in urban areas than in rural
areas.
Suppose that many of our computer professionals migrate to
foreign countries. Ceteris paribus, how will it affect the salary
of computer professionals in India and abroad?
153

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U N I T- I

1.1 Central Problems of an

1.2 Production Possibility

1.3 Micro versus Macro

Welcome to the science of economics. Yes,

Unfortunately, this may be true only in

rainfall etc. It is partly influenced by

India was receiving Rs. 2.58 lakhs per

engineers would now have more

Alternatively, in a centrally planned

1.2 PRODUCTION POSSIBILITY

on sugar cane, and, this will give him

(Assume that all cricket bats are of the

resources are scarce. As more resources

Table 1.1 Production Possibilities

An introduction to graph plotting and joining points is given in Appendix 1.

PPC shows the maximum amount that

India) or resources work inefficiently (e.g.

Production Possibility Curve

PPC is downward sloping, because

We already know that, along a PPC,

The concept of downward sloping is explained in Appendix 1.

marginal opportunity cost (per

Increasing marginal opportunity cost

Marginal Opportunity Cost along the PPC

in New Delhi, earning Rs. 4 lakhs

Shift of the PPC

1.2.3 Shift of the PPC

then the economy can produce more of

So far we have discussed in general

On the other hand, macro economics

in an economy? What policies can

* We need not mention NET in every clip.

Economics is a social science.

Economics is concerned with the study of individual and social choice

The how problem refers to the choice of methods of production of goods

In a capitalist or market-oriented economy, these problems are addressed

Normally, the production possibility curve is concave to the origin. It is

A production possibility curve shifts out due to technological progress

What is economics about?

Explain how scarcity and choice go together.

Draw the production possibility curve for the example of

Give two examples of under-utilisation of resources.

A country produces two goods: green chilli and sugar. Its

2.1 Consumer's Equilibrium

2.3 Market Demand Curve

In Chapter 1 it was stated that, in a marketoriented economy, the central problems of

Final goods and services include things that are consumed

suppliers and the fir ms are the

unit be called utils. Thus, the total

with the 10th unit be -7 utils. That is,

or service, the marginal utility from it

How many Gol Guppas will

From Table 2.1, it is clear that if you

Marginal and Total Utility

were free, i.e., its price were zero, you

example, the 5th gol guppa is worth

Difference between Total Utility in Terms of Money and Total

section is titled Consumers

consumers equilibrium with respect to

2.1.3 The General Principle

From the example just worked out, we

Marginal Utility of a Product

Marginal Utility of a Product