F.Y.B.

A Lecture Notes

Dr. Ranga Sai
Vaze College, Mumbai

Micro Economics
[With effect from 2007-08]

First Year Bachelor of Arts Micro Economics

With effect from June 2007

Dr.Ranga Sai

First Year Bachelor of Arts Micro Economics
With effect from June 2007 Section I Module 1: Introduction Meaning and scope of micro economics, Ceteris paribus assumption, concepts and types of equilibrium: partial and general Module 2 Consumer Behavior: Cardinal and ordinal approaches – Indifference curve – consumers’ equilibrium, income, price and substitution effects; Giffen’s paradox – Revealed preference Hypotheses – elasticity of demand: price, income, cross and promotional – consumer surplus, Engel curve Module 3: Production and costs Production; short run and long run – law of variable proportions – isoquants, iso-cost line and producers’ equilibrium – returns to scale – economies of scale – Cobb-Douglas production function Module 4: Costs and revenue Costs: short run and long run cost, derivation of short run cost curves and their relationship – derivation of long run average cost curve and its features. Revenue: Total revenue, average revenue and marginal revenue: relationship between AR and MR under different market structures: relationship between AR, MR and elasticity of demand. Section II Module 5: Theory of firm Objectives of a firm: Profit, sales and growth maximization – breakeven analysis – analysis of equilibrium of a firm – pricing methods in practice: marginal cost and full cost approaches Module 6: Perfect competition Perfect competition: features; short run equilibrium of the firm and industry: derivation of supply curve of the firm and industry; long run equilibrium of firm and industry Module 7: Monopoly Monopoly : features, short run equilibrium and monopolist under different cost conditions and long run equilibrium of the monopolist; discriminating monopoly, equilibrium under discriminating monopoly, dumping – comparison between perfect competition and monopoly with respect to out put and price Module 8: Monopolistic competition and oligopoly Monopolistic competition; features, equilibrium in the short and in the long run , wastages under Monopolistic competition, features of oligopoly.

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CONTENT
Introduction Meaning and scope of micro economics, Ceteris paribus assumption, Types of equilibrium Consumer Behavior: Cardinal and ordinal approaches Indifference curve – consumers’ equilibrium, Income, price and substitution effects; Giffen’s paradox Revealed preference Hypotheses Elasticity of demand: price, income, cross and promotional Consumer surplus, Engel curve Production and costs Production function Law of variable proportions Isoquants, producers’ equilibrium – Returns to scale – economies of scale – Cobb-Douglas production function Costs and revenue Cost concepts: Short run Long run cost, Revenue concepts Relationship between AR and MR. Theory of firm Objectives of a firm Pricing methods in practice: marginal cost and full cost approaches Perfect competition Perfect competition: features; Short run equilibrium of the firm and industry: Derivation of supply curve of the firm and industry; Long run equilibrium of firm and industry Monopoly Monopoly: features, short run equilibrium and different cost conditions long run equilibrium Discriminating monopoly Dumping Comparison between perfect competition and monopoly Monopolistic competition and oligopoly Monopolistic competition; features, Equilibrium in the short and in the long run , Wastages under Monopolistic competition, Features of oligopoly.

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without any restrictions. are made available to all. who will be writing their Micro Economics examinations on or during and after 20007-08. These notes will be useful to all the F. Prof.Y. This is neither a text book nor an original work of research.Ranga Sai Dear Student friends… During these days of commercialization it becomes very difficult to find information on web which is relevant.e.f.A. Dr. June 2007) 4 .Y.com June 2010 Micro Economics.B. We believe that knowledge should be free and accessible to all those who need. authentic as well as free. (w. We solicit your opinions and suggestions on this endeavor. Mumbai.A students of University of Mumbai.Dr.B. We no way intend to replace text books or any reference material. Ranga Sai rangasai@rangasai. complied to help the students readily understand the subject and write the examinations. This is purely for academic purposes and do not have any commercial value. F. Feel free to use and share. Distance Education students are advised to refer the recommended syllabus. which are originally intended for the students of Vaze College. It is simple reading material. With this intention the notes.

Depending on the market the prices are determined which fulfill the consumer objectives as well as the firm objectives. In detail the microeconomics deals with decisions at 1.e. Exchange: The buyers and sellers meet at the market. Ceteris paribus Ceteris paribus is a Latin phrase. Consumption: The consumer aims at maximizing consumer satisfaction. They have conflicting interests. Production: The producer has to coordinate inputs to produce goods so that the out put is maximized and the cost is minimized. The individual can be a consumer. June 2007) 5 . costs and factors. he has to optimize his performance within the limitations of income and prices 2. pricing and determination of factor prices. or a household. "Microeconomics deals with the decision making and market results of consumers and firms".Y. Welfare: Welfare economics uses micro economic tools in defining and optimizing welfare of a society. (w. Microeconomics deals with economics decisions made at individual level. Distribution: Distribution deals with determinations of factor prices.Ranga Sai Module 1: Introduction Nature and scope of Micro Economics Micro economics is that branch of economics which analyzes the market behavior of individual consumers and firms to understand the decisionmaking process of firms and households. the producer/firm. 4. Most micro economic theories are partial equilibriums which provide in depth details of a specific economic activity.Dr.f. The producer has to optimize. 3. 5. Micro economic theories help in the designing the models of demand forecasting. consumer behavior models. It is important in the determinations of factor incomes/ household incomes.A.B. F. which means “all other things being equal or held constant” Micro Economics.

By holding all the other relevant factors constant. Economic equilibrium is not permanent. income-Y. The demand function relates the quantity demanded-Q. At equilibrium.A. it assumes all factors to be constant and isolates one major determinant. the objectives of economic activity are achieved.Y. Quantity demanded. Any change in any one of the factor. the equilibrium will undergo a change. Micro Economics. Q = f (P.A. (or ceteris paribus). In economics the laws are made based on the cause and effect relationship. The equilibrium is valid as long as the factors determining it remain unchanged. The clause of keeping other factors constant by retaining one major determinant for the purpose of forming a law is called as ceteris paribus.e. The equilibrium is attained by a set of two or more economic forces. (w. These functional relationships relate one dependent variable and several independent variables. for separating factors which interfere while studying a cause and effect relationship.T/F) Yet while studying the relationship as a law. • Consumer equilibrium – consumer satisfaction is maximized.f. June 2007) 6 . Economic equilibrium Equilibrium is a state of rest where there is no urge to change. Ceteris paribus represent relationships (such as demand and supply) between two variables (such as price and quantity). in order to isolate the influence of one independent variable (such as price) on the dependent variable (such as quantity). as an effect of several factors like price-P. holding all other things constant. and tax-T. Y. advertising-A. • Producers’ equilibrium – the cost are minimized • Market equilibrium – the price and quantity are so determined that are acceptable to both buyers and sellers. a cause and effect relationship can be studies in greater detail.Ranga Sai A ceteris paribus assumption is used to formulate scientific laws.B. F.Dr.

Micro Economics. It is the state of rest at macro level.Ranga Sai Static equilibrium: In economics static equilibrium refers to rigid models which do not accept more or changing variables. Micro economic theories are mostly partial equilibriums. Micro economic theories deal with partial equilibrium. input-output matrix of national income accounting provide relationships as well as determinants at each level of economic activity. al other related variables are kept constant.A.g. The equilibrium explains only a part of the economic activity. the equilibrium is attained. effective demand.f. .B.Dr. Subject to the given set of variables. So the general equilibrium may not provide depth of details as in case of partial equilibrium. e. The output of one sector becomes the input for the other sector.e. Circular flow of incomes. General equilibrium in turn deals with macro economic state. Equilibrium at macro level has to provide description at aggregate level. consumer decisions. F. They are applied in pricing. Such economic models have large application in policy making e. demand forecasting etc. General equilibrium is useful in policy and planning. These are specialized theories providing in-depth details.g. circular flow of incomes. June 2007) 7 . (w.it explains the relationship between various economic activities Dynamic equilibrium: It is an advanced economic model which gives relationships between several economic variables and can also accommodate change. This is an advanced model of explaining circular flow of incomes. input output tables are example of general equilibrium. Such equilibrium may not have large policy applications. General equilibrium was first used by Lean Walrus to explain unity of equilibrium at consumption and production.Y. Partial and General Equilibrium Partial equilibrium deals with a state of rest between few variable but has a large ceteris paribus clause. Since the theories deal with a specific activity.

form utility. air.Ranga Sai Module 2 Consumer Behavior Utility analysis of consumer behavior given by Marshall is based on the cardinal measure of utility.A. June 2007) 8 . Such utility is classified as time utility. With increasing use value of good its exchange value decreases. This is called the law of equi-marginal utilities.B.g. (w. Under the utility theory the consumer behavior is explained by the Law of diminishing marginal utility. The theory is based on the basic assumption that the utility can be measured. place utility.g. Use value is the value of a good in use.a good changes utility form place to place. F.e.e. the theory describes utility as the want satisfying capacity of a good.f. Similarly with increasing exchange value its use value decrease . The consumer maximizes his satisfaction by equating marginal utilities of all the goods he consumes.where the good changes utility with changing form. According to the law ‘with the increasing use of a good its marginal utility decreases’. gold But a transaction can take place only when use value is equal to exchange value.a good changes form time to time depending on the seasons. on the other hand deals with what a good can get in return in the market. e. Exchange value. water.Y. It depends on thr want satisfying capacity of the good.Dr. This conflict is called as value paradox. The value paradox states that use value and exchange value are inversely proportional. Micro Economics. Accordingly. diamonds.

the theory will suggest the consumer the way in which satisfaction van be maximized. The theory is an improvement over Utility analysis. The consumer will be indifferent between these combinations. Indifference Schedule X 1 2 3 4 Y 12 10 7 3 All these combinations give the consumer same amount of satisfaction. Utility analysis had a major draw back that it measured utility in cardinal terms.e. Indifference curve analysis is a consumption theory given by Hicks and RGD Allen. In utility analysis. In this case the consumer will not be able to choose any combination as better than other.Y. the theory studies the consumer behavior and secondly.A.Dr. (w. IC deals with various combinations of two goods which give the consumer the same amount of satisfaction. The curve drawn indifference schedule is called the IC.B. F. the Law of Diminishing marginal utility studies consumer behavior and the law of Equi-marginal utilities suggested a method of maximizing consumer satisfaction. IC analysis provides wider descriptions and details as compared to utility analysis.f. June 2007) 9 . Further. Indifference curve analysis measures utility in ordinal terms.Ranga Sai Indifference Curve Analysis Consumption theory in economics contains two parts. Firstly. Micro Economics. ICs can be understood better with the help of its properties. Hicks use an IC to explain the consumer behavior.

3.Y. Indifference curves never touch the axis. In fact an IC should necessarily represent two goods always.A. In the diagram IC 1 represents lower satisfaction and IC2 represents higher satisfaction. By touching the axis the indifference curve will represent only one good. June 2007) 10 . Indifference curves towards the axis represent lower satisfaction and IC away from the axis represents higher satisfaction.f. Indifference curve is a down ward sloping curve.Dr. Higher the consumption higher the satisfaction and lower the consumption lower the satisfaction 2.B. This is because on higher IC the consumption increases and on lower IC consumption decreases. (w. F. A consumer has to sacrifice one goods to gain the Micro Economics.Ranga Sai Properties of Indifference curves 1. It slopes down from left to right. It can be seen that for the same amount of Y the consumer gets +2 on IC2 and gets -2 on IC1.e.

Ranga Sai other. MRS = ∆y/∆x. June 2007) 11 . F. The marginal rate of substitution.f. is the rate at which a substitutes one commodity with the other. By gaining one commodity the consumer shall sacrifice the other.e.Y. (w. 4. that is the rate of substitution is 4/1 Micro Economics. On an indifference curve the marginal rate of substitution decreases.A. This is essential to keep the level of satisfaction constant on an IC. the consumer sacrifices 4 Y for 1 X. The marginal rate of substitution decreases on an IC. the slope of an indifference curve.B.Dr. On the diagram it can be seen that On the upper half. This is needed to keep the level of satisfaction constant on an IC.

Comparing the IC analysis and the Utility analysis it can be seen that the marginal rate of substitution is equal to the ratio of the marginal utilities. In this process the rate of substitution decreases from 4/1 to 1/ 4. a straight line has constant slope or constant MRS hence not an IC.e. the consumer equates 1Y with 4 X. June 2007) 12 . Micro Economics.e. Only on a convex curve the marginal rate of substitution decreases.Dr. This is because on the upper half the consumer has more of Y so he likes more of X and lower half he has more of X so he likes more of Y. Slope of an IC is found by drawing a tangent. An indifference curve is convex to the origin.Y.A. The slope of the tangent is the slope of IC at that point. F. (w. So it is not an IC. MRS = ∆Y/∆X = .MUx/MUy 5. Similarly.f.Ranga Sai On the Lower half it can be seen that the rate of substitution is 1/ 4 i.B. On a concave curve the slope of IC increases that is MRS increases. On an IC the consumer expresses his utility behavior through decreasing Marginal rate of substitution.

e.A. June 2007) 13 .f. In the diagram it can be seen that Combination A gives larger satisfaction. inconsistent and irrational. Converging indifference curves are accepted to be correct. an IC. Indifference curves do not intersect. Indifference curves need not be parallel. Foundations of Assumptions of Indifference curves: Indifference curve analysis is based on the following assumptions: 1.B. yet it is on two indifference curves IC1 and IC2.Ranga Sai A curve convex to the origin has decreasing slope or decreasing MRS. (w. because it is on a lower indifference curve IC2 But Combination C gives same satisfaction. Transitivity: It is assumed that the combinations are continuous to form a curve. Two indifference curves can not give same satisfaction. hence. The combinations between two tested sets are given. Intersection of Indifference curves is considered to be illogical. because it is on a higher indifference curve IC1 And Combination B gives smaller satisfaction. Indifference curves need not be parallel. Converging indifference curves are accepted to be correct but they shall not intersect.Dr. 2.Y. Micro Economics. Ordinality: The indifference curve analysis considers ordinal measure of utility. This is illogical. inconsistent and irrational. 6. 7. F. That is utility is compared but not qualified.

Ranga Sai 2. He always prefers higher satisfaction to the lower and he knows all the combinations giving him same satisfaction or different satisfactions.A. Scale of preference: On a series of indifference curves the consumer has a preference increases from low to high. F. the consumer can buy any combination on the line or combinations below the line. Real income is what the consumer can buy with his money income. Given the price line. This is only the possibility of buying and does not represent the choice of the consumer. The consumer always prefers higher satisfaction to lower. the price line will shift upwards on a single axis (shift on X axis if the price of X decreases) Micro Economics. June 2007) 14 .Y. Rationality: The consumer is rational. With this. Convexity: A convex indifference curve represents the consumer behavior.e.Dr. The price line deals with various combinations of two good that a consumer can buy with in his limited income.f. It is made up of the money income of the consumer and the prices of two goods. (w. This is called the scale of preference. 4. Price Line The price line represents the budget of the consumer.B. When the price of a good decreases the real income of the consumer increases. 3. The convex IC shows the utility behavior with out actually measuring utility in cardinal terms.

Dr.Ranga Sai

Similarly, if the money income increases the price line will shift upwards parallel on both axes.

Consumer equilibrium
The consumer equilibrium suggests the method in which he consumer can maximize satisfaction with in the given limitations of money income and prices. The indifference curve analysis is an improvement over the utility analysis. It is given by Hicks and RGD Allen. As an improvement IC analysis uses ordinal measure of utility in place of cardinal measure. Assumptions Consumer equilibrium is based on the following assumptions: 1. The prices of two goods are given and constant. 2. The money income of the consumer remains constant 3. The tastes and preferences of the consumer remain same 4. The consumer is rational, i.e. the consumer prefers larger satisfaction to smaller satisfactions. 5. The theory follows all the foundations of indifference curves, like convexity, transitivity, ordinality and scale of preference. The consumer equilibrium considers the indifference map and the price line. The indifference map represents the consumer behavior, tastes and preferences of the consumer. On the other hand the price line represents income and the prices of two goods. The indifference curve is made up of combinations the consumer wants to consume on the other hand the hand the price line denote the combinations the consumer can buy. Consumer equilibrium determines such combinations which the consumer can buy, those which he likes and finally gets maximum satisfaction.

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The consumer equilibrium is derived by combing the indifference curves and the price line. In the diagram IC3 is possible because the consumer can not reach this with his limited income. IC1 is possible because there are several combinations with in the budget; price line IC2 and the price line have one combination common. At the point of tangency between the IC and price line i.e. E. This is the consumer equilibrium. A combination which offers maximum satisfaction and is also falls with in the price line.

Conditions of Consumer Equilibrium The consumer equilibrium is found at a place where Indifference Curve (IC) and Price Line (PL) are tangential.
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Or

Slope of the price line = Slope of the Indifference curve Slope of the price line = Marginal Rate of substitution [Equilibrium condition]

In the diagram E1 is not equilibrium because slope of IC > Slope of PL E2 is not equilibrium because slope of IC < Slope of PL At E Slope of IC= Slope of PL, hence equilibrium

There are two conditions of consumer equilibrium a. Necessary Condition: Tangency is a necessary condition. It is case of optimizing satisfaction. In the diagram E2 is a necessary condition. Yet it is not the equilibrium.

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Income Effect Income effect shows the effect of changes in the money income of a consumer on his consumption. June 2007) 18 . All other things remaining constant if the money income of the consumer increases. (w.e.f. An upward shift of price line indicates an increase in the income. whether normal good. The increase in consumption of X is called income effect. When the money income increases the consumer shifts on to IC2.Ranga Sai b. Tangency represents mathematical optimization and convexity denotes consumer behavior. Such consumer equilibrium remains valid as long as the price and money income remain unchanged. With an increase in the income the consumer will consume more. Micro Economics.Y. If we join the points of equilibrium an income consumption curve can be drawn. The IC will shift upwards on the new price line. F.Dr. inferior or Giffen’s good.A. Sufficient condition: Tangency + convexity is sufficient condition. In the diagram E2 is necessary condition. It fulfills tangency as well as convexity. the price line will shift upwards parallel. The increase in the consumption of a commodity is called income effect. Income consumption curve shows changes in the consumption of a commodity for changes in money income. The nature shape of the ICC indicates the nature of commodity.B.

B. F. ICC3: If the ICC slopes forwards to the right. The prices of two goods are given and constant.Ranga Sai With increase in the money income if the consumption increases it is called positive income effect and if consumption decreases with increasing income it is called negative income effect. transitivity. June 2007) 19 . This is called Substitution effect.e. The consumer is rational.Y. Y is inferior with negative income effect and X is normal with positive income effect. 5. X is inferior with negative income effect and Y is normal with positive income effect. 2. The theory follows all the foundations of indifference curves.f.Dr. ordinality and scale of preference.e. The tastes and preferences of the consumer remain same 4. The money income of the consumer is given and subject to changes.A. (w. 3. the consumer prefers larger satisfaction to smaller satisfactions. ICC1: If the ICC slopes upwards to the right both X and Y are normal goods with positive income effect. like convexity. Substitution Effect When the price of commodity decreases the consumer substitutes a costlier commodity with a cheaper commodity with out affecting the level of satisfaction. i. Assumptions Income effect is based on the following assumptions: 1. ICC2: If the ICC slopes backwards. Micro Economics. The nature of income effect determines the shape of the Income Consumption Curve.

Y. the price line will shift upwards on that axis. For Giffen’s goods substitution effect is positive but very weak.Dr. When the price decreases the consumer shifts on to IC2.A. All other things remaining constant if the price of a commodity increases.B. An upward shift of price line indicates an increase in the real income. June 2007) 20 . F.e. whether normal good. Price Effect Price effect shows the effect of changes in the price of a good on consumption. the movement from Eq1 to E2 is called substitution effect. The increase in consumption of X is called price effect.Ranga Sai In the diagram. The movement is on the same IC showing that the level of satisfaction remains same. The increase in the consumption of a commodity is called price effect. The nature shape of the PCC indicates the nature of commodity. The IC will shift upwards on the new price line. Substitution effect together with income effect constitutes the price effect. inferior or Giffen’s good. Assumptions Price effect is based on the following assumptions: Micro Economics. With an increase in the real income the consumer will consume more. Price consumption curve shows changes in the consumption of a commodity for changes in price.f. If we join the points of equilibrium a price consumption curve can be drawn. (w. The substitution effect is always positive for normal as well as inferior goods. The consumer consumes more of X by sacrificing Y.

Thus. The theory follows all the foundations of indifference curves.Dr. When a commodity becomes cheaper the consumer has a natural tendency to substitute the costlier commodity with a cheaper commodity. The tastes and preferences of the consumer remain same 4. The money income of the consumer is given and constant. The prices of two goods are given and the price of one good only changes.Y.e. 2.A. June 2007) 21 .Ranga Sai 1. The real income increases and the consumer consume more of a commodity. This is called income effect. Price Effect= Income Effect+ Substitution Effect . 5.e. b. ordinality and scale of preference. (w. 3. F. The consumer is rational.f. i. When the price of a commodity decreases: a. Micro Economics. This is called as substitution effect. the consumer prefers larger satisfaction to smaller satisfactions. Composition of Price Effect Price effect is made up of income effect and substitution effects.B. transitivity. like convexity.

There are some inferior goods where the price effect is negative.e. June 2007) 22 . the price effect is positive. The price effect depends on the components . The exception to the law of demand is negative price effect. A parallel downward shift indicates decrease in the income. These goods with negative price effect are called Giffen’s goods.A.B. The movement from E1 to E2 is called Price effect To separate income effect from price effectShift the price line parallel from E2 downwards. This is same as the law of demand.Ranga Sai In the diagram E1 is the consumer equilibrium With a decrease in the price of X the price line shifts upwards and the consumer will shift on to IC2 at equilibrium E2.f. The income effect is negative but very weak.income and substitution effects. Micro Economics. the price effect remains positive.Dr. The price line shall be shifted to such level on IC1 that the consumer comes back on to his original level if satisfaction. The consumption from E1 to E3 is substitution effect. (w. so as to reach IC1 at E3. The substitution effect is positive and very strong. Inferior Goods In case of inferior goods in general. found on the same IC. So finally. Income Effect Substitution Effect Price effect Normal Goods Inferior goods Giffen’s Goods +ve -ve (weak) -ve (strong) +ve +ve (strong) +ve (weak) +ve +ve -ve For normal goods the price effect is positive because the components income and substitution effects are positive. F. The price effect is positive for normal goods and inferior goods.Y. With a decrease in income effect the consumption is reduced to E3. According to Hicks the price line should be shifted on to lower IC such that the ‘consumer is neither better off nor worse off’ Nature of Price Effect Positive price effect means with a decrease in the price the consumption increases.

Dr.A.B. Giffen’s Goods Giffen’s goods are those inferior goods where the income effect is strongly negative and substitution effect is weak. June 2007) 23 . So. Micro Economics.f. F. (w. This is negative The movement from E1 to E2 is positive substitution effect which positive and strong.Ranga Sai In the diagram: The movement from E3 to E2 is negative income effect.e.Y. the movement from E1 to E2 is positive price effect. Inferior goods in general follow the law of demand with positive price effect. finally.

F. By joining all the points the demand curve can be drawn on the lower panel. the movement from E1 to E2 is negative price effect.Ranga Sai Giffen’s goods re inferior goods but all inferior goods are not Giffen’s goods. Derivation of demand curve from Price Consumption Curve For drawing the demand curve there is a need for a set of prices and corresponding quantities. The quantities from different equilibriums are drawn on the lower graph with X axis marked quantity. The corresponding quantities can be read fro the X axis at different equilibriums. So. finally. The price at different quantities can be plotted on the Y axis.e. Each price line represents one price of commodity X.A. This is negative and strong The movement from E1 to E2 is positive substitution effect which positive but week.Dr. June 2007) 24 .f.B. In the diagram: The movement from E3 to E2 is negative income effect. The Price Consumption curve shows different price lines. Giffen’s goods are those inferior good which have a negative price effect. Micro Economics.Y. (w.

Y. hypothetical ep = 0. income elasticity or cross price elasticity of demand. it is called price elastic.A. necessary goods ep = ∞. Perfectly inelastic. Relatively elastic.f.B. Price elasticity is measured as The price elasticity has a negative value. Perfectly elastic. F. Price elasticity relates quantity demanded and the price. luxury goods ep < 1. because the price decreases for an increase in the quantity demanded.Dr.Ranga Sai Elasticity of Demand Elasticity of demand measures intensity of changes in the quantity of a commodity for changes in the price.e. Price Elasticity of demand Price elasticity of demand measures proportionate changes in the quality of a commodity for proportionate changes in the price. reference elasticity ep > 1. (w. Accordingly. June 2007) 25 . hypothetical Micro Economics. Relatively inelastic. ep = 1. income or the price of a related commodity. Unitary elastic.

Ranga Sai The value of elasticity changes with changing responsiveness of quantity changes for changes in the price. For highly sensitive quantity.Dr. F. the elasticity will be infinity. (w.B. Larger the responsiveness greater will be the elasticity. June 2007) 26 . Micro Economics.e.Y.f.A. No change in the quantity the elasticity will be zero.

Income elasticity relates quantity demanded and the income.Dr. F. Micro Economics.f.Ranga Sai Income Elasticity of demand Price elasticity of demand measures proportionate changes in the quality of a commodity for proportionate changes in the income.Y.e. (w.A.B. June 2007) 27 .

Inferior goods effect ey = 0. Relatively inelastic. F. Unitary elastic.B. necessary goods ey < 0. Perfectly inelastic. (w.A. Relatively elastic. June 2007) 28 .Ranga Sai With an increase in the income the consumer increases the consumption.e. ey = 1. reference elasticity ey > 1. Incase of inferior goods with increase in the income the consumer degreases the consumption. This is called negative income effect. hypothetical positive income effect positive income effect positive income effect negative income Cross Price Elasticity of Demand Micro Economics.Dr.Y. luxury goods ey < 1.f. This happens in case of normal goods. hypothetical ey = ∞. For normal goods the value of income elasticity is positive for inferior goods it is negative. Perfectly elastic.

June 2007) 29 . Complementary goods When the price of X increases. Cross Price elasticity relates quantity demanded of one commodity and the price of a related commodity.A. the consumer increases the demand for Y. Complementary goods are those which give utility only in combinations. exy < 0. the demand for x decreases. X and Y are substitutes. Since the goods give similar utility the consumer can consume one in the place of the other.Y. Substitute gods are those goods which give similar utility. Since. the demand for x decreases. Since.g. Micro Economics. pen and ink exy > 0. The value of cross price elasticity depends on the type of relationship between the goods. the consumer decreases the demand for Y. X and Y are complementary goods.Dr.B. F.Ranga Sai Price elasticity of demand measures proportionate changes in the quality of one commodity for proportionate changes in the price of a related commodity. Substitute goods When the price of X increases. These are called joint goods having joint demand. (w. shoe and shoe lace.f.e. e.

This principle can be shown geometrically on a demand curve using point elasticity of demand method.Y.Dr. hypothetical e > 1. The demand curve is extended on both sides so as to make a right angle triangle. luxury goods e < 1. Point Elasticity of Demand According to Lucas all goods tend to be elastic at higher prices and inelastic at lower prices. Perfectly elastic. Micro Economics. Relatively elastic. necessary goods e = ∞.f. Relatively inelastic.e.B. F.Ranga Sai exy = 0. Perfectly inelastic. (w. reference elasticity e = 0. Unitary elastic. hypothetical Promotional Elasticity of Demand Promotional elasticity of demand measures proportionate changes in the sales of a commodity for proportionate changes in the promotional budget. The elasticity increase as it moves upon the demand curve to the left. Unrelated goods If the price of X increase the demand for Y remains unchanged this is because the goods are unrelated and independent in consumption and utility.A. Then the elasticity at point is measured as E= Lower segment Upper segment BC AB Or So e = 1. It is ratio of lower segment to the upper segment. June 2007) 30 .

By selecting a combination of goods he rejects all other combinations revealing his preference for consumption. By doing so the consumer optimizes his satisfaction within the limitations of income and prices. free samples. sales promotions. Revealed preference Theory Revealed preference theory s based on the observed behavior of the consumer. advertising. It is assumed that the consumer has not arrived at saturation.Dr.A. hence undesirable.Ranga Sai Price elasticity relates sales and the promotional budget. So the consumer can always go for higher satisfaction. The consumer selects combination P o the price line MN. It enables the enterprise to decide whether a sales promotion budget is desirable or not in terms of generating corporate incomes and sales. F.B. gifts. The consumer continues to be with this combination as long as the price and income remains same.f.Y. promotional offers etc.e. The revealed preference theory is given by Paul Samuelson. Micro Economics. (w. The promotional budget may have components like media. This is the case of revealed preference. This is a case of strong order preference. June 2007) 31 . Promotional elasticity is a managerial tool of corporate decision making. An elastic promotional elasticity means that the sales are in larger proportions than the promotional budget and desirable. If the promotional elasticity is less than one that inelastic it means that the promotional budget has failed in promoting proportionate sales. A consumer during his consumption selects a combination of goods. This is called as the nonsatiety condition.

This price is uniform for all the earlier units. F. June 2007) 32 . (w. The consumer can no longer afford P .Y.Dr. So he leaves combination P.e. This is because the utility decrease with in creasing consumption as per the law of diminishing marginal utility. A consumer pays the price according to the utility drawn on the last commodity. However. In this process the consumer derives surplus utility over the price paid on earlier units.B.f.Ranga Sai The consumer will leave this combination only when he can no longer afford. the price line will shift down wards. If the price of A increases. According to the law of demand the price decreases with increasing quantity.A. This surplus utility is called the Consumer Surplus. if there is an increase in money income the consumer will rearrange his preference in a manner to attain P again Consumer Surplus Consumer surplus is the excess of Utility drawn over the price paid. Consumer surplus = Utility derived – price paid Micro Economics.

The producer surplus is the surplus of price charged by the producer over the supply price. 3. 1. (w.e. June 2007) 33 . 3.f. Micro Economics. There is perfect competition. 4. The utility can not be measured 2. The law of demand is considered for determining the price.Dr. 5.B. Limitations The concept of consumer surplus has several limitations due to its rigid assumptions.A. The price is charged as per the last unit produced. The supply curve shows that the price increases with increasing quantity. The supply of goods is uniform.Ranga Sai Consumer surplus is the excess of utility derived by consumer. The price remains uniform. whereas the producer receives a surplus over the supply price. This is called consumer exploitation. The tastes of the consumer remain constant 6. Consumer surplus can not be easily quantified. This is called producers’ surplus. F. The concept believes in the law of diminishing marginal utility 2. The producers’ surplus can be increased by reducing consumer surplus. Market imperfections deny consumer surplus to the consumer.Y. Assumptions 1.

A. Micro Economics. June 2007) 34 . (w. F. It helps on price discrimination.Y. 5. It helps in determining the price. 3. The shape and slope of Engel curve depends on the shape and slope of ICC. 4.B.f.Dr. Thus Engel’s curve is derived on the lower graph. normal or inferior. The Government can determine tax based on consumer surplus. Larger the consumer surplus. The Income consumption curve tells us about changes in consumption from changes in income. Consumer surplus helps in demand forecasting. Applications: Consumer surplus is a very useful concept applied in marketing. Such increase in consumption is marked on the lower graph against corresponding changes in the money income. 5. ICC depends on the nature of goods whether. product design and pricing. Necessities have larger consumer surplus than luxury goods. Marketing techniques increase consumer surplus by showing greater utility and then in crease price. ICC can be used for deriving the Engel curve Each shift in the price line represents increase in the money income.e.Ranga Sai 4. the producer charges different prices for the same commodity depending on the consumer surplus. greater the possibility of increasing the price. With such shift the ICs shift upwards and the consumption increases. necessary good or luxury. Consumer surplus encourages the government to levy tax. Engel Curve Engel curve relates changes in consumption for changes in the income. 2. 1. Under monopoly.

Ranga Sai Module 3: Production and costs Production function A production function provides the relationship between out put and various factors of production.B. There can be short run production function and the long run production function. In the long run all factors change. So.e. F.f. June 2007) 35 . the cost structure may be totally renewed. when all factors change there can be large changes in the out put can be brought. Between time periods the nature of factors can change.Y. The production function can be classified as per time period. the expression of long run production function will be Micro Economics. A production function is a functional relation between the inputs and out put.Dr. the technology can change.A. (w.

(w. = f ( labour / F . The short run production function will always carry the expression fixed and variable. raw material. Q = f ( Labour. machinery / T) Where T. power.Y. According to the law of variable proportions. separately. initially. Q. c. Fixed factors remain fixed even with changing out put. raw material. So the expression of production function will have fixed and variable factors. F.A. T) Where F represents the fixed factors which remain unchanged in the short run and T is the level of technology given and constant. an embedded (associated) factor of production. buildings. It studies the behavior of out put for changing variable factor. b. June 2007) 36 . It is the qualitative description of capital. then slowly and finally decreases’. Quantity of out put.f. the out put will increase rapidly.B.e. Law of variable proportions The law of variable proportions studies the relationship between one variable factor and the out put. The fixed factors become more productive. T) Where F represents the fixed factors which remain unchanged in the short run and T is the level of technology given and constant. It deals with a short run production function with one variable factors with all other factors are given and kept constant. The variable factors become more and more productive. land. In the short run certain factors are fixed certain other variable. = f ( labour. Q. ‘all other factors remaining constant. power/ F . I Stage: Stage of increasing returns During the first stage the out put increase rapidly because a. if the usage of one variable factor increases. The elasticity of production is more than 1 ( Ep>1) Micro Economics.Ranga Sai Quantity of out put.Dr. is technology. On the other hand variable factors change with changes in the out put.

MP and TP are increasing.B. The elasticity of production is more less 1 ( Ep<1) Micro Economics. June 2007) 37 .e. AP=MP and TP continues to increase. (w. The factor substitution becomes limited b.Y.A. MP reaches a maximum called as the point of inflexion.Dr.f. Other factors become less and less productive c.Ranga Sai During the first stage AP. At the end of the stage. From this point onwards there will be a change in the level of factor productivity. F. Total Labour Product Units TP Average Product AP Marginal Product MP Production Elasticity Stages of production 1 2 3 4 5 6 7 5 8 15 24 30 30 28 5 4 5 6 6 5 4 0 3 7 9 6 0 -2 Ep>1 Increasing returns I Stage Ep<1 Ep<0 Diminishing returns II Stage Negative returns III Stage II Stage: Stage of diminishing returns During the second stage the out put increase slowly because a.

There is perfect competition in product and factor markets. MP decreases and TP is increasing. F. All factors re given and remain constant and only labour changes 2. MP<AP. Isoquants An isoquant is made up of various combinations of two factors which give rise to a fixed amount of out put. 4. June 2007) 38 . The Micro Economics. This is the area where there is factor substitutability.T) where K . 3. AP. MP and TP are all decreasing. Further. (w. Isoquants away from the origin represent higher out put and isoquants towards the axis represent lower out put.L / F . but slowly.e. Variable factors are of similar productivity.Capital. Output = f (K. Assumptions: 1. The elasticity of production is less than o ( Ep<0) During the third stage. Each Isoquant deal with a specific level of out put. c. Isoquant deals with a production function with two variable factors.A.Dr. kept constant in the short run and T – the technology given. The ridge lines give the limits of factor substitutability.B. Factors of production are not perfect substitutes. F – fixed factors. The area between the ridge lines is called the economic zone. There will overcrowding of one variable factor b. The Isoquant depends on the level of factor substitutability. Fixed factors also become less productive.f. The level of technology remains same. At the end of the stage MP=0 II Stage: Stage of negative returns During the third stage the out put decreases because a.Ranga Sai During the second stage AP decreases but it is slower than MP.Y. L – labour.

By choosing isoquant we consider a production function with two variable factors all other factors and technology remaining constant. Such slope of isoquant depends on the nature of factors and intensity of production. This can be done by using isoquants.B. F.Capital.f. L – labour. because the factor substitutability ends. The Marginal rate of technical substitution is the manner one factor is substituted by the other factor so as to give a fixed output through out the isoquant. (w. A producer will be a t a state of equilibrium when he produces a desired level of out put at a cost which is least. F – fixed factors.T) Where K .Ranga Sai analysis is confined to this area alone. Micro Economics.A.L / F . The area out side the ridgelines can not be used for any study. The slope of the Isoquant represents the Marginal rate of technical substitution (MRTS). June 2007) 39 . kept constant in the short run and T – the technology given. Producers' equilibrium (Least cost combination) Producers’ equilibrium deals with a least cost combination of producing a specific level of out put the producer would like to produce.e.Dr. It is the ratio of change in K for changes in L.Y. Output = f (K.

(w. 2. the isoquant is selected. When all the points of equilibriums or the least cost combinations at different levels of out put are joined. All other factors are given and constant 4. Assumptions 1. June 2007) 40 .B.A. F. Least cost combination is the combination of two factors which will produce a given level of out put at least cost. There are different least cost combinations for different levels of out put. The prices of two factors are given and remain unchanged. The level of technology remains same 3.Y.Dr.e. Mathematically. There is perfect competition in factor and product markets. Or the slope of the price ratio line is same as the Marginal rate of Technical Substitution.Ranga Sai Firstly the producer will determine the level of out put to be produced. Micro Economics. the production path or the scale line can be derived. Least cost combinations are found at different levels of out put by following the condition of producers’ equilibrium. The producers' equilibrium finds the least cost combination. The producers' equilibrium is found at a place where the slope of the isoquant is same as the factor price ratio line. the slope of the isoquant is equal to the slope of the price ratio line. Producers’ equilibrium considers a production function with two variable factors.f.

If the production path is towards the capital axis it is capital intensive.Ranga Sai The shape and position of the scale line will indicate the type of technology or the intensity of factor usage.e. the cost structure may be totally renewed. (w. the technology can change. F.Dr. In the long run all factors change.f. machinery / T) Micro Economics. Q = f ( Labour. Laws of Returns to Scale The laws of returns to scale deals with the long run production function.Y. when all factors change there can be large changes in the out put can be brought. June 2007) 41 . buildings. power. the expression of long run production function will be Quantity of out put.B. land. So.A. if it is toward the labour axis the technology is labour intensive. raw material.

The out put may increase in lesser proportions than the in puts used called Diminishing returns to scale. Increasing returns to Scale According to Increasing returns to scale In the long run when the scale of production increase. the out put may increase in larger proportions than the inputs used called increasing returns to scale Increasing returns to Scale .B.Y.f. L – labour. F – fixed factors. 1. (w.Capital. Output = f (K.Dr. is technology.Ranga Sai Where T. a. F.Decreasing costs Micro Economics. an embedded (associated) factor of production.L / F . The laws of returns to scale can be explained with the help of isoquants. kept constant in the short run and T – the technology given. and E4 decreases . It is the qualitative description of capital. June 2007) 42 .T) Where K . The out put may increase in the same proportions as the inputs used called Constant returns to scale OR c.The gap between E1.e. E2. The out put may increase in larger proportions than the inputs used called Increasing returns to scale OR b.Economies of scale . By choosing isoquant we consider a production function with two variable factors all other factors and technology remaining constant.A. According to the laws of returns to scale In the long run when the scale of production increase. E3.

Y. E3.Dr. (w. The firm is a said to be operating on neutral economies. In the long run the firm derives certain advantages called economies of scale. The firms neither get nor loose any advantages due to large scale production.Constant costs In case of constant returns to scale the out put increases in the same proportions as the inputs. In the diagram it can be seen that the gap between the isoquants keep on decreasing thus showing that lesser and lesser factors are needed for producing additional output. These economies of scale can come from within called internal economies or come from out side the firm called external economies. F. This is called decreasing costs.The gap between E1. June 2007) 43 . 2.Neutral Economies of scale . and E4 remains constant .e.f. In the diagram it can be seen that the gap between the isoquants remain constant thus showing that same ratio of factors are needed for producing Micro Economics.B. Constant returns to scale In the long run when the scale of production increase. Due to economies of scale the costs keep on decreasing.Ranga Sai The out put responds positively because. it operates on economies of scale. E2. the out put may increase in the same proportions as the inputs used called Constant returns to scale Constant returns to Scale .A.

Y. The scale of production increases Micro Economics. In the long run the firm may face certain disadvantages called diseconomies of scale. E2.B. June 2007) 44 . Assumptions: 1. Diminishing returns to scale. This is called increasing costs.Dr. F. the out put may increase in lesser proportions than the in puts used called Diminishing returns to scale. (w. it operates on diseconomies of scale. Due to diseconomies of scale the costs keep on increasing.f.The gap between E1.A.Increasing costs The out put responds discouragingly. and E4 increases . Diminishing returns to Scale . This is case of constant costs 3. It is case of long run production function 2. The per unit costs remain constant.e. These diseconomies of scale can come from within called internal diseconomies or come from out side the firm called external diseconomies. E3. In the diagram it can be seen that the gap between the isoquants keep on increasing thus showing that more and more factors are needed for producing additional output. In the long run when the scale of production increase. because.Diseconomies of scale .Ranga Sai additional output.

Ranga Sai 3.Dr. These advantages are called economies of scale. These factors are exogenous to the production function. Micro Economics. When the firm increases the scale of production it gets certain advantages. Economics of Scale In the long run all factors becomes viable and the firm can increases its scale of production. Internal economies of scale These are the advantages the firm gets from the factors within the firm. F.B. Economies of supervision: Better supervision will improve the factor productivity in the long run.A. This will add to the revenues of the firm. External economies of scale These are the advantages the firm gets from the factors out side the firm. Managerial economies: In the long run the firm will have better managerial talent in organizing factors for better productivity. A. 5.Y. backward integration will enable a firm produce such factors which were earlier bought form the factor markets.e. 4. 3. These factors are endogenous to the production function. Economies of by product: The firm will be able to develop waste into marketable by product in the long run. 7. 1. There is a perfect completion in factor and product markets. 8. Technology remains same 4. June 2007) 45 . Technical economies: The firms will have improved technology in the long run and the firm will progressively reduce costs. 6. This is due to established market and strong finances. Risk bearing economies: Firms will greatly increase capacity to take risk with new products and technologies in the long run. Economics of specialization: The firm may develop certain specialization in the long run depending on the production function and acceptance in the market. B. Economies of cost: With improved supply chain and labour productivity the costs will reduce in the long run. This again reduces the cost and adds to the profit margins.f. Each isoquant represents a fixed increment of output. 2. (w. This may create niche and better price. Economies of integration: In case of forward integration the firm will undertake an additional process of production and add value o the out put. The revenue will increase Similarly. 5.

Ranga Sai 1. The function they used to model production was of the form: Where: • P = total production (the monetary value of all goods produced in a year) • L = labor input (the total number of person-hours worked in a year) • K = capital input (the monetary worth of all machinery. 3.15% increase in output. and buildings) • b = total factor productivity • α and β are the output elasticities of labor and capital.B. if: α + β = 1.f. That is. Economies of environment: In the long run the firm becomes more environmentally friendly with larger investment on pollution control and resource conservation Cobb-Douglas production function The Cobb-Douglas production function represents the relationship between output to inputs The Cobb-Douglas production function deals with short run production with two variable factors. The production function has constant returns to scale.Dr. These values are constants determined by available technology.Y. (w. Micro Economics. if L and K are each increased by 20%.15. The firm will also have better institutional axis for raising more finance easily. a 1% increase in labor would lead to approximately a 0. Output elasticity measures the responsiveness of output to a change in levels of either labor or capital used in production.e. For example if α = 0. then P increases by 20%. Further. F.A. ceteris paribus. equipment. respectively. June 2007) 46 . Economies of finance: The firms will have better financial position in the long run due to accumulated profits. Economies of marketing: The firms will be able to market with ease due to establishment of brand and dealership network 2.

As against this. If output increases by less than that proportional change. The major consideration is optimizing usage of factors for cost reduction and maximizing profits. On the other hand the social cost deal with the burden of production on the society. Returns to scale are increasing.e. Financial costs and physical costs: Financial costs are economic costs mentioned in uniform value terms. 3. It is the analysis in retrospection. There are financial cost and social costs.f. and resource conservation. there are increasing returns to scale. 1. environment. Most of the social costs can not be quantified. and If α + β > 1. However. Since all the factors are Micro Economics. if α + β < 1. Returns to scale are decreasing. each suitable for a different purpose.Ranga Sai Returns to scale refers to a technical property of production that examines changes in output subsequent to a proportional change in all inputs (where all inputs increase by a constant factor).Y. Financial cost and social costs: Financial costs are private costs. But these cots are very important in terms of social objectives and justice. the economic cost study the nature of costs. (w. the costs paid by a firm to procure factors for creating out put. F. accounting cost and economic costs. their behavior and methods of optimizing cists for minimizing cost of production and maximizing profits. June 2007) 47 . short run and long run costs and the opportunity cost. output increases by that same proportional change then there are constant returns to scale. Accounting cost and economic costs: Accounting costs consider documentation of expenditure for purpose of future analysis. If.Dr. there are decreasing returns to scale. Module 4: Costs and revenue Costs There are several concepts of cost developed.B. If output increases by more than that proportion.A. 2. The analysis deals with spent money.

Dr. In addition there are four per unit costs.A. average cost and the marginal cost. In the shot run there are three costs . total variable cost and total cost.average fixed cost. Accordingly. (w. Any payment less than this will make the factor leave the production function and join an alternative use. Physical costs on the other hand are factors mentioned in dissimilar units.total fixed cost.e.Ranga Sai mentioned in uniform terms. The factor price needs to be equal to or greater than the opportunity cost. 4. Opportunity Cost: Opportunity cost is the cost of a factor in its alternative use.B. This is the minimum which needs to be paid to bring a factor in use. it is easy to apply any quantitative or statistical method for regulating their usage and optimizing for profits. the costs will be Micro Economics. The concept of opportunity cost is useful in determining the factor price. F. Since they are dissimilar in expression and quantitative. Yet physical costs are important for production planning and procurement of factors. average variable cost. June 2007) 48 . it is not easy to apply techniques of quantitative analysis. certain costs are fixed and certain costs variable. Larger the opportunity cost higher will be the factor price. Short run Cost curves In the short run certain factors are fixed certain other variable.Y. Illustration: for a given TFC of 100 and TVC over 8 units.f.

At zero level of out put the total cost is equal to total fixed cost. June 2007) 49 .Dr.A.e. 2. (w. 3. F. Average Fixed cost Average Fixed Cost = Total fixed cost Out put Micro Economics. This it has three segments. Total variable cost The total variable cost increases with increasing cost. The shape of the variable cost curve is drawn form the law of variable proportions.Y.Ranga Sai Out put 1 2 3 4 5 6 7 8 TFC 1000 “ “ : “ “ “ “ TVC 100 180 240 340 480 680 980 1480 TC 1100 1180 1240 1340 1480 1680 1980 2480 AFC 1000 500 333 250 200 166 142 125 AVC 100 90 80 85 96 113 140 185 AC 1100 590 413 335 296 179 282 310 MC 80 60 100 140 200 300 500 1.f. At zero level of out put the total cost is equal to total fixed cost. The fixed cost curve is a horizontal curve parallel to x axis. Total cost Total cost = Total fixed cost + Total variable cost The total cost is the sum of total fixed cost and total variable cost. At zero level of out put the variable cost is zero. 4.B. Total Fixed cost The fixed cost remains constant in the short run at level of out put. The shape and size of total cost is similar to total variable. cost but it starts form total fixed cost.

but never touches the axis.Dr. Micro Economics. The shape is derived from the behavior of marginal product in the law of variable proportions.e. Average cost is minimum when AC = MC 7. change in the trend and upward trend: a.TC n Marginal cost curve is a J shaped curve. down ward part. AFC continues to decrease but AVC increases.f. It passes through the minimum point of AC. F. the increasing AVC is stronger than decreasing AFC and AC now continues to increase. There is a change it the trend. AVC and AFC are both decreasing so the resultant AC also decreases b. on this curve the product of coordinates always a constant. The decreasing curve now changes trend towards increase. 5. Average Cost Average Cost = Total cost Out put Or Average Cost = Average Fixed cost + Average Variable Cost Average cost curve is a U shaped curve.Y. The Ac curve takes a U shape.Ranga Sai Average fixed cost curve is a downward sloping curve.A.B. 6. Finally. Average Variable Cost Average Variable Cost = Total Variable Cost output Average variable cost is a broad U shaped curve. Initially. June 2007) 50 . It keeps on decreasing. The short run Average Cost Curve is a U shaped Curve The U shape of the average cost curve is made up of three segments. c. AC curve lies above AVC. (w. When AC=MC. the shape is derived by the combination AC and AVC. the shape of the curve is drawn from the behavior of variable facto and the law of variable proportions. It is asymptotic to x axis. Marginal cost Marginal cost = TC (n-1) . There after. Geometrically. Marginal cost is minimum.

F. This is case of decreasing costs In the long run.B. The long run AC is derived from the short run AC. (w.e. Micro Economics. when the scale of production increases.A. June 2007) 51 .Dr. Long run costs The long run cost curves are derived from the short run cost curves. This is due to economies of scale. the gap between AVC and AC is equal to AFC.f. This is case of constant costs. This is due to neutral economies of scale. the AC curves shift down wards showing decreasing costs. the AC curves may shift horizontally to the right.Ranga Sai Further. In the long run when the scale of production increases. Average Cost = Average Fixed cost + Average Variable Cost So.Y.

e. This is case of decreasing costs The long run AC is made up of these three segments. F.f.” Long run Marginal cost curve passes through the minimum point of LAC. Micro Economics. The LAC is also called the envelope curve. June 2007) 52 . the AC curves shift upwards showing increasing costs.Dr.Y.A. Thus the LAC is flatter than the SACs. This is due to diseconomies of scale.Ranga Sai In the long run when the scale of production increases.B. For this reason “The long run average cost curve is flatter than the short run average cost curve. (w.

Population Though population changes even in the short run. mass consumption in the economy increases. Alternative sources of raw material and energy Alternative and cheaper sources of raw material and energy change the production function and help in expanding out put and making it economical. Revenue concepts Total revenue (TR): This is the revenue got by the firm by selling certain amount of out put. 2. Average Revenue (AR): This is the average proceeds per unit. F. Revenue relationships under perfect competition Micro Economics.f.A.B. In the long run. The effect of population can be seen only in the ling run. 4. For this reason. Technology Technology helps in the ling run in reducing costs and making production function efficient.Dr. Expanding markets Expanding markets provide purpose for the industry to produce and distribute. Marginal Revenue (MR): This is the additional revenue got by affirm by selling an additional unit. This is same as the price. the demand curve is same as the average revenue curve. June 2007) 53 . by way of changes in the pattern of demand and labor force. (w.Ranga Sai Following are the long run factors responsible for flatter long run average cost curve: 1. 3.e.Y.

This is the reason why a firm continues to get the same price at any level of out put. there is no distinction between firm and industry.B. Incase of perfect competition.Dr. Revenue relationships under imperfect competition A monopolist faces a downward sloping demand curve: Under monopoly. Under perfect competition the number of firms is so large that no single firm can. June 2007) 54 . A firm can produce only an insignificant part of the total out put. the industry faces down ward Micro Economics. Quality 1 2 3 4 5 6 Price 10 10 10 10 10 10 TR 10 20 30 40 50 60 AR 10 10 10 10 10 10 MR 10 10 10 10 10 10 Under perfect completion the firm is a price taker and it has to determine that level of out put which will give maximum profits. F.f.Ranga Sai The price under perfect competition is determined by the industry. The firm has also AR=MR in revenue relationships.A. (w. It means that the fir has a demand curve with infinite elasticity. A single firm is too insignificant to determine the price. alone. Larger number of firms together determines the price.e.Y. influence the price. The demand is direct on to the firm.

It means that the firm can sell more only by reducing price. (w. With this difference. MR curve cuts the plane below AR curve into two halves. it has a property: A perpendicular drawn on Y axis will show ab = bc. MR curve lies below AR curve. Micro Economics. Geometrically.e.B.f. F. June 2007) 55 .Y.Ranga Sai sloping demand curve and the firm gets the perfectly elastic demand curve. the relation ship between AR and MR also changes Quality 1 2 3 4 5 Price 10 9 8 7 6 TR 10 18 24 28 30 AR 10 9 8 7 6 MR 10 8 6 4 2 Relationship between AR and MR AR and MR are downward sloping curves. In case of monopoly the firm directly faced the downward facing demand curve.A.Dr.

Y.B.Ranga Sai Relationship between Elasticity of demand and Revenues Where e – is the point elasticity of Demand.e. AR is average revenue and MR is Marginal Revenue. June 2007) 56 .A. F.f. Micro Economics. (w.Dr.

Economic objectives are normally considered by all firms.Y. These economic objectives can be classified as follows: 1. Following are some of the important objectives of a firm. Certain firms may have material objectives significant certain other firms may have normative objectives significant. economic. a.f. short run. June 2007) 57 .A. However the firm may decide its own priorities in objectives. F. (w.B. Economic objectives Economic objectives are material objectives which may be short as well as long run. Some objectives are uniformly significant for all firms. long run material and non material in nature.Dr. This is a universal objective for firms. Micro Economics. All objectives are important. The firms aim at maximizing the difference between total revenue and total cost.Ranga Sai Section II Theory of firm Objectives of Firm The firm may have several objectives ranging from. Profit maximization: Each firm tries to maximize profits.e.

Firms may aim at maximizing rate of profit or profit. The slope of TC is MC and slope of TR is MR. Workers welfare Workers welfare helps in maintaining harmonious relationships and also maintaining high levels of productivity and loyalty. 3. market share. (w. market share and growth.Y. Creating brand equity Every firm aims at creating a brand and as large consumer following as possible. By equating slopes. Specialization Specializing in certain product or service will be useful in establishing brand image. Micro Economics. This is in the long run interest of the firm.B. MC=MR emerges as equilibrium condition for optimizing out put for a firm. Consumer satisfaction Consumer satisfaction helps in maintaining brand image.Dr. Investors benefit In case of joint stock companies. 2. Accordingly. Long run objectives 1. 4. Market leadership The firm wills always aim at being the market leader. In the long run the competition may increase.A. it will have a investor friendly policy in dividends and bonus. The gap between TR and TC can be maximized by drawing two tangents. 5. one on each with same slope.f. MC is equated with MR. prevents defection of consumers to another brand. So. This is the objective before aspiring for market leadership. The rate of profit is maximized by pricing so that there is larger gross profit margin. 3. b. 2. 6.e. the firm will aim at increasing the net asset value of the company. F. On the other hand maximizing profit may be attained by maximizing out put. Increasing market share The firms will initially aim at increasing market share.Ranga Sai The firm will produce such out put which will give maximum profit. In most cases profit depends on this objective. in such a market the basic principle is to survive. Survival The basic objective of firm is to survive in the long run. June 2007) 58 . This is a material objective as well as normative objective.

After break even point the profitability begins. At break even point total cost is equal to total revenue. c.A. F. Non material objective 1. and aforestation. Creating social infrastructure The firm may create social infrastructure by constructing educational institutions. This is dome by being eco-friendly and having less pollution. June 2007) 59 .B. Break even Analysis Break even out refers to the level of output where TR = TC. hospitals. This is the minimum out put the firm need to produce its costs.e. The break even level is a no profit no loss condition. It is give back from the society from where the firm makes a living. Any output there after will grant profit to the firm. 3. Growth: forward and backward integration The firm may go for forward integration thus adopting an additional process of production or take up backward integration whereby. The costs cover only the manager’s remuneration and there is no surplus over that. produce locally such component which was earlier brought form the factor market. It is similar to the condition AR = AC.f. The society benefits form resource conservation 4. 2. Social responsibility The forms may assume social responsibility as an important factor. Resource conservation The resource conservation may help in reducing costs but it also helps in reducing social costs. (w. townships. The out put less than break even out put shows losses.Dr. Every firm aims at break even level of output in the beginning. In other words it is case of normal profits. Usage of break even point for corporate decision making is called Break even analysis. Micro Economics.Y. Environmental protection The firm may work in the direction of protecting the environment.Ranga Sai 4.

F.Ranga Sai At break even point there are no profits.A. (w.e.f.Dr.Y. June 2007) 60 . so TR = TC Where.B. TR is total revenue TC is total cost P is price AVC is average variable cost TFC is total fixed cost Q is out put Break even analysis is based on the following assumptions Micro Economics.

Because a firm will always wishes to keep the Break even out put small so that. If the angle of incidence is larger the break even out put will be smaller.A. June 2007) 61 . 4. (w. Application of Break even analysis A firm will firstly. While comparing competing projects on the basis of break even points. The angle of incidence decides the nature of break even point. The cost and revenue functions are linear functions. 2. a project with larger angle of incidence will be selected.e. In break even analysis the angle of incidence is very important in selecting a project among various competing projects. attain the break even out put so that it can be out of losses and start making profits.Y. Micro Economics. 3. F. In other words. This is for the sake of simplicity. if the angel of incidence is smaller the break even out put will be larger.f.Ranga Sai 1.Dr. Price remains uniform at all levels of out put. it can operate on profits hat sooner. The firm can estimate the cost and revenues in advance. The costs are made up of fixed and variable costs. Angle of Incidence The angle of incidence is the angle made by the TR and TC functions at the break even point.B.

Dr. marketing overheads can be deducted. It is that part of fixed assets that is consumed during the year and that part of fixed cost that can be charged to the out put. Depreciation is a nominal expenditure. Micro Economics. Limitations 1. the firm will slot revenue for depreciation on assets. as it tells you nothing about what sales are actually likely to be for the product at these various prices. Firstly. When a firm makes profits it has to pay taxes.Y. The firm now provides for taxes after deducting depreciation.f.e.Ranga Sai However. (w. Break-even analysis is only a supply side analysis. the firm needs to allot revenues for different purposes depending on the earnings of profit or revenue. F. Thereafter. So if the revenue permits the firm may provide for durable marketing overheads. These marketing overheads are for more than one year.B.A. the revenue in excess of all these provisions yield profits that can be distributed among owners or retained as reserves and surplus. June 2007) 62 . Depreciation is the first priority after attaining break even out put. Finally.

B. It assumes average variable costs are constant per unit of output. Micro Economics.e. 5. it assumes that the relative proportions of each product sold and produced are constant Pricing Methods in practice Marginal Cost Pricing The Conventional pricing is followed when MC = MR. June 2007) 63 . the price is determined by AR curve. Marginal Cost pricing: when AR=MC.Dr.Y. the price tends to be smaller. It assumes that the quantity of goods produced is equal to the quantity of goods sold 6. In multi-product companies. Further. The Marginal cost pricing is more advantageous than conventional pricing because. F. The conventional pricing is described by the theory of firm and pricing. the out put tends to be larger than the conventional method.A.f. This as an optimizing output will help in determining the price as per the AR (demand) curve.Ranga Sai 2. the price is equated with Marginal Cost. (w. Independent of markets and competition the pot put is determined by equating MC and MR. It assumes that the price remains uniform at levels of out put 3. It assumes that fixed costs are constant 4.

The costs include all the variable costs and part of fixed cots. The Government follows this method for pricing petroleum prices.Ranga Sai This is the method followed by the Government in most administered pricing methods.B. The cost sheet approach to pricing includes relevant inputs of production and overheads. The considerations of average and marginal costs are no more valid. Under administered pricing the Government can also follow Average cost pricing: when AR=AC. where the price includes all the costs chargeable to the product.A. The fixed cost is represented in different ways As per the standard accounting procedures. June 2007) 64 . Out line of cost sheet: Direct labour + direct material+ direct expenses Prime cost + Production over heads Works cost + administration overheads = Prime cost = Works cost = Cost of production Cost of production + selling and distribution over heads = Cost of sales Full cost pricing considers all relevant costs and over heads. The price is lower and the out put is higher. the price is equated with Average Cost. thus achieving efficient allocation of resources. Full Cost Pricing The corporate pricing practices are mostly based on the cost sheet approach. The resources are put to efficient use when the price equated with MC. F.Y.e. Administered pricing refers to the pricing adopted by the government in determining the price of a product independent of market and profitability considerations. This is a pricing where the firm will be operating at normal profits.Dr. the fixed cost is represented as depreciation. The consumption of fertilizers is desirable in the national interests in increasing the output of agriculture. It is that part of the fixed capital that is consumed during Micro Economics. The government follows this method for pricing products like fertilizers. (w. Thus way the government can encourage the consumption of a product and also utilize the production capacity fully. In this case the out put is highest and the price is lowest.f.

4. F.f. The system can be integrated in multi. Fixed costs Fixed costs are correctly represented. 3. Extendable to multi commodity or multi location pricing A firm producing multiple goods or producing from various locations can use the method easily. The price so determined is called as the price of the product as per full cost pricing or profit mark-up method.Y. Alternatively. This is because of its several advantages 1. Flexible The system is very flexible. the fixed cost can be represented as the interest on fixed capital for that year.A. full cost pricing is realistic 2.Dr. Price = Mc + Lc+ FC+ π q Where. To this cost the firm will add a profit mark up. June 2007) 65 . 5. Realistic representation of creation of utility The cost represents the actual inputs going into production representing their scarcities and productivities. (w. Micro Economics. Easy for firms to adopt Since it is simple and provides great scope for analysis of cost of production it is commonly adopted by firms. Simple cost sheet method enables the firm to apply the system across time and products. Mc is the cost of material Lc is the labour cost FC is the fixed cost apportioned to the out put q π is the profit mark-up Full cost pricing a popular method of pricing method.product pricing and branch accounting. The costs which can be assigned to the out put are correctly drawn.B. 6. In both the cases the fixed capital is represented in the cost of production.e.Ranga Sai that year on out put. Represents all costs As against the conventional pricing methods. The amount charged on the out put pit depends on the life span of the asset and cost of replacement.

June 2007) 66 . competition.e. Whether the product is at introduction. further. long run equilibrium of firm and industry Perfect competition refers to a competition between large umber of buyers and sellers dealing in homogenous product at uniform price. 7. Pricing strategy Having a certain degree of Profit mark-up can be matter of corporate strategy. It is the gross profit margin. The profit mark-up depends on several factors 1. Product life cycle The product life cycle decides the degree of Profit mark-up. Cost of capital The cost of capital has a direct bearing on the levels of Profit mark-up expected. Industry standard Every industry has its own standard of Profit mark-up. perishable or similar. growth. short run equilibrium of the firm and industry: derivation of supply curve of the firm and industry. May it be hospitality. Profit mark-up changes in each case. Expected rate of return or profitability Each firm will have its own expected rate pf return on investment. 3. F.f. Determination of Profit mark-up is matter of great care and risk. Firms determine the Profit mark-up depending on several factors.Ranga Sai Profit mark-up Profit mark-up is the rate of return expected by the firm on its sales. each has its own degrees of Profit mark-up. Micro Economics. It is an internal matter for a firm. There is a direct relation between these. consumer durable. stagnant or decay will all have a Profit mark-up of their own. Highly competitive markets will have lower Profit mark-ups. Corporate policy The policy of the firm will determine the level of profit mark-up 2. Nature of market and competition Market and competition have great bearing on the Profit mark-up.B. housing or consumer goods. 7. The Profit mark-up will depend on that. luxury good.Dr. (w.A. 6. Nature of product The product can be consumer good. 4. 5. automobile. Module 6: Perfect competition Perfect competition: features.Y.

Free mobility of factors of production Free mobility of factors ensures that the cost of factors is same across all the regions. Price determination under perfect competition (Industry) Micro Economics.A.Y.B. This is possible only when the firms cater to local markets. 6. 4. No transport cost The transport cost should be insignificant as compared wt the cost of production. Homogenous product The product is homogenous. With new firms joining the super normal profits. so that no form has a reason to charge a different price. Large number of buyers and sellers The number of buyers and sellers should be so larger that no firm can determine the supply or no single buyer can determine demand and no singe person can determine the price. F. Perfect knowledge The buyers and sellers have perfect knowledge of \demand. 5. Uniform price Uniform price ensures that the consumers have choice between firms and the firms have no reason to charge different price due to homogenous product. June 2007) 67 . 7.Ranga Sai Features of perfect competition 1. Equal factor prices give all the firms same opportunity to make profits and survive. because each firm will have infinite market at the given price.e. So in the long run. efficient firms which can operate at normal profits only exist. So. Advertising will add to cost and reduce profits 8. Free entry and exit of firms: When there is free entry and exit of firms. No advertising The firms need not advertise. 9. 3. 2. get distributed among more and more firms.Dr. In the long run the perfect competition has only firm which operate on normal profits.f. (w. the firms keep joining the production as long as there are profits. At the same time when the profits decrease the less efficient firms leave the industry. supply and price. No Government restrictions There are no government interventions by way of taxes or mobility of goods. efficiency of firms will determine the profitability of firms.

Under perfect competition the price is determined by the firms and buyers.Ranga Sai The price under perfect competition is determined by the industry. It is an ideal situation whether both the buyers and the sellers are equally represented. Micro Economics. F. This is determined by the large number of buyers and spellers. to sell goods at different price The cost conditions Nature of factor markets Supply and demand curve together determine the equilibrium price.f. June 2007) 68 .e. The buyers are represented by demand curve and the firms are represented by supply curve. the supply curve indicates The willing ness of the firm.A.Dr.B. no single firm or buyer can influence the price. Perfect competition is a market condition where the buyers and sellers are equally important in the determination of price. (w. The equilibrium price is the one which is acceptable to both buyers and sellers. The demand curve indicates The choice and tastes of the consumers The utility of the good The utility behavior of the consumer The capacity and willing of the consumer to pay the price Similarly.Y.

Larger number of firms together determines the price. (w. The equilibrium quantity and price remain unchanged as long as the demand and supply remain constant. June 2007) 69 .B. Perfect competition encourages efficiency of firms.Y. A single firm is too insignificant to determine the price. the equilibrium is a natural process. Goods are not being sold. The price remains unchanged as long as the demand and supply remain constant. Micro Economics. influence the price. price is high At P2 D<S. This is the reason why a firm continues to get the same price at any level of out put. the demand and supply get equated automatically. Perfect competition is an assumption for all the theories of economics.Dr. F.Ranga Sai Price 10 9 8 7 6 Quantity demanded 600 700 800 900 1000 Quantity Supplied 1000 900 800 700 600 D<S D<S D=S D>S D<S Market Surplus Surplus Equilibrium Scarcity Scarcity At P1 D<S. Nature of perfect competition: Demand and supply are both responsible in the determination of equilibrium. A firm can produce only an insignificant part of the total out put.e. It is an ideal situation whether both the buyers and the sellers are equally represented. It leads to efficient allocation of resources.A. According to classical economics. Under perfect competition the number of firms is so large that no single firm can. there is scarcity.f. the firms do not accept low price At P3 D=S. It means that the fir has a demand curve with infinite elasticity. Out put determination under perfect competition by a firm Perfect competition is a market condition where the buyers and sellers are equally important in the determination of price. alone. the price is acceptable to both sellers and buyers This is the equilibrium price. The price under perfect competition is determined by the industry.

(w.A. one on each with same slope.Ranga Sai Quality 1 2 3 4 5 6 Price 10 10 10 10 10 10 TR 10 20 30 40 50 60 AR 10 10 10 10 10 10 MR 10 10 10 10 10 10 Under perfect completion the firm is a price taker and it has to determine that level of out put which will give maximum profits.e. At a point where MC=MR the difference between TC and TR will be maximum. The slope of TC is MC and slope of TR is MR. MC is equated with MR. The firm has also AR=MR in revenue relationships. F. these condition the firm will optimize its out put at a point where MC=MR. Conditions of out put determination: While maximizing out put the firm shall follow two conditions I Order condition: MC=MR II Order Condition: MC cuts MR from below. Micro Economics.Dr. June 2007) 70 . The gap between TR and TC can be maximized by drawing two tangents.B.f. By equating slopes. Given.Y.

B.e. normal profits and super normal profits or incur losses. June 2007) 71 . he will receive normal profit as his share of remuneration Micro Economics. Normal profit: A firm is said to be making normal profit when AR = AC.Y. F. whether perfect competition or imperfect competition. Nature of firm A firm can make profits or incur losses depending on the price and costs. MC=MR emerges as equilibrium condition for optimizing out put for a firm. A firm can earn profits. If the entrepreneur him self is the manager. This is true in case of any firm. The price (AR) covers the costs.Ranga Sai So. Each on of this will determine the nature of firm. maximum bearable loss and shut down condition. However there is no surplus above managers’ remuneration. The cost includes the managers’ remuneration.A. (w.f.Dr.

e.f. (w. In this case the firm receives the managers’ remuneration (normal profits) and also a surplus over it.Dr. Super Normal profit: A firm is said to be making supernormal profits if AR > AC.B. Losses Micro Economics. June 2007) 72 . The price charged by the firm covers all the costs and also generates a surplus over the expenditure.Ranga Sai Normal profit is also called ‘no profit no loss’ condition or break even point in managerial economics. F. Hence it is called super normal profits.Y.A.

If the firm continues to produce the loss will be fixed cost and a part of variable cost. AR < AC. So.Ranga Sai A firm is said to be making losses if. F. Maximum bearable loss: If AR = AVC the firm is said to be at maximum bearable loss. the firm can reduce losses by closing down. This is called the maximum bearable loss.f. In case of loss there is a need for further analysis.B. the loss remains same (fixed cost) whether the firm stays in production or shuts down. in the short run the fixed cost remains as loss.A. So if the firm closes down the loss is equal to fixed cost. This is called Shut down condition Micro Economics. This is a case where. June 2007) 73 . The price received covers the AVC and the fixed cost is not covered. Shut down Condition If AR < AVC. So even if the firm closes down. In such a case Average variable cost (AVC) is considered. (w. The firm needs to decide whether to stay in production or shut down.e. the firm needs to close down. The price received fails to cover fixed cost as well as a part of variable cost.Y.Dr.

A firm determines its out put at a point where MC=MR. it is known that AR = MR = P.B. So.Ranga Sai Derivation of Supply curve from MC Supply curve of a firm can be derived from the MC curve.e.A. the out put of the firm also changes. If MR keeps changing. Micro Economics. the out put also changes from Q1 to 2 to 3 to 4. June 2007) 74 . The form produces certain out put at MR1. Under perfect competition. As the MR keeps changing from MR1 to 2 to 3 to 4.Y.f. These changes can draw the supply curve.Dr. MR can be considered as price. (w. F.

A.f. So in the long run. (w. However. F. The AR=MR received by the firm also decrease.Dr. the firms keep joining the production as long as there are profits. supply becomes more and more elastic. at the same time the average cost curve also becomes flatter. Flatter AVC means more out put being produced at lesser cost. showing decline in costs. Long run equilibrium under perfect competition In the long run the following factors operate: The supply becomes more elastic: With time. So the price tends to decrease.Y. There is free entry and exit of firms: When there is free entry and exit of firms. June 2007) 75 . The out put and price remains directly proportional. get distributed among more and more firms. In the long run the perfect competition has only firm which operate on normal profits. efficient firms which can operate at normal profits only exist. At the same time when the profits decrease the less efficient firms leave the industry.Ranga Sai This data of out put and prices can be drawn a different graph to get the supply curve.B.e. The nature and shape of MC curve determines the nature and shape of the supply curve. Micro Economics. With new firms joining the super normal profits.

Y.Ranga Sai The long run average cost curve becomes flatter than short run cost curve Following are the long run factors responsible for changes in average cost curve in the long run: 1. 2. Technology Technology helps in the ling run in reducing costs and making production function efficient. F. by way of changes in the pattern of demand and labor force. Expanding markets Expanding markets provide purpose for the industry to produce and distribute. 3. mass consumption in the economy increases. 4.B.A. The effect of population can be seen only in the ling run. In the long run. and Micro Economics. Population Though population changes even in the short run. June 2007) 76 .e. (w.Dr. LAC = LMC indicate the firm operating at optimum level. Alternative sources of raw material and energy Alternative and cheaper sources of raw material and energy change the production function and help in expanding out put and making it economical.f. Hence in the long run the equilibrium of the firm is arrived at a point where: LAC = MR (long run) = LMC = AR(long run) Where MR (long run) =MC represents determination of optimum out put.

B. Monopoly is identified with single firm large number of buyers and the monopolist as the price maker. (w. Product: The product may be homogenous or even differentiated depending on the nature of market and division of submarkets. Following are the features of monopoly market.Y. Personal monopolies: Personal monopolies have individual branding. Registered trade marks and brands: I case of registered trade marks. firms can not duplicate and compete in a market. Government monopolies on entry b.A. the monopoly power remains intact d. There is no distinction between firm and industry.e. However there may be differences in the elasticity of demand in each segmented market. Large number of buyers: There is a large market even under monopoly. Legal restriction: The law may prevent other firms from entering. a. June 2007) 77 . e.Ranga Sai LAC = AR (long run) means the firm is operating on normal profits Module 7: Monopoly Monopoly refers to an imperfect market situation where a single seller sells the product in different markets at uniform or discriminating prices. Exclusive ownership of technology of production: If the technology of production is known only to a single firm the monopoly power remains un effected. Features of Monopoly 1.g. They can not be duplicated. This is due to the monopoly power the firm has. Since a single firm supplies to the large number of buyers. c. The personal monopolies continue Micro Economics. the firm tends to be large and specializing in its production 2. E. Monopoly power: The entry into monopoly market for other firms is restricted.Dr.f. The monopoly power is got by the firm due to following factors. Single seller: The monopoly market has a single firm. It remains as monopoly. 3. 4. Exclusive ownership of raw material: Access to raw material is held by a single firm. F.

It can be seen that AR is greater than MR. 6. Further. With this difference. there is no distinction between firm and industry. This will change the AR and MR relationship. the relation ship between AR and MR also changes Relationship between Average revenue and Marginal revenue under monopoly A monopolist faces a downward sloping demand curve.Ranga Sai 5. The demand is direct on to the firm.Y. so he can sell more only by reducing the price. (w.B. AR is not equal to MR. Price discrimination: With price discrimination a monopolist sells the same product at different prices in different markets at the same time. Since it is an imperfect market.Dr. F. Incase of perfect competition. The objective of price discrimination is profit maximization.e. It means that the firm can sell more only by reducing price. AR and MR are related through elasticity of demand. Q 1 2 3 4 5 Price 10 9 8 7 6 TR 10 18 24 28 30 AR 10 9 8 7 6 MR 8 6 4 2 Micro Economics. In case of monopoly the firm directly faced the downward facing demand curve. the industry faces down ward sloping demand curve and the firm gets the perfectly elastic demand curve.A. June 2007) 78 .f. A monopolist faces a downward sloping demand curve: Under monopoly.

June 2007) 79 . (w.e.Ranga Sai Geometrically.Y. In case of simple monopoly. When MC = MR the difference between TC and TR will be maximum. This is the demand curve which will tell the maximum price that can be charged for this level of out put.B. At a point where MC = MR the firm finds its equilibrium out put. AR curve cuts the plain below AR into two halves. the demand curve is downward sloping. However the optimizing condition for out put remains same as in case of perfect competition.Dr. F. So any perpendicular drawn on Y axis will show the property. The output is found on the x axis. In case of differentiated monopoly Micro Economics. The price determination is done by AR curve.f.A. there will be only one product and single price. so the AR and MR curves also slope down wards and look different. ab = bc Equilibrium under simple monopoly Under monopoly.

The cost includes the managers’ remuneration.e. Hence it is called super normal profits. F. whether perfect competition or imperfect competition.Ranga Sai Nature of firm A firm can make profits or incur losses depending on the price and costs. June 2007) 80 .Y. Each on of this will determine the nature of firm. The price (AR) covers the costs. This is true in case of any firm. normal profits and super normal profits or incur losses. A firm can earn profits.A. If the entrepreneur him self is the manager. Micro Economics. Normal profit: A firm is said to be making normal profit when AR = AC. (w.Dr.f. The price charged by the firm covers all the costs and also generates a surplus over the expenditure. he will receive normal profit as his share of remuneration Normal profit is also called ‘no profit no loss’ condition or break even point in managerial economics. In this case the firm receives the managers’ remuneration (normal profits) and also a surplus over it.B. Super Normal profit: A firm is said to be making supernormal profits if AR > AC. maximum bearable loss and shut down condition. However there is no surplus above managers’ remuneration.

A.Dr. the firm can reduce losses by closing down. If the firm continues to produce the loss will be fixed cost and a part of variable cost. June 2007) 81 . The firm needs to decide whether to stay in production or shut down.e. Micro Economics.Ranga Sai Losses A firm is said to be making losses if.f. AR < AC. So.B. (w. In such a case Average variable cost (AVC) is considered.Y. In case of loss there is a need for further analysis. This is called Shut down condition. So if the firm closes down the loss is equal to fixed cost. F. the firm needs to close down. The price received fails to cover fixed cost as well as a part of variable cost. Maximum bearable loss: Shut down Condition If AR < AVC.

the out put is determined.Dr. AC and MC curves will be upward sloping.e. The price is determined as per AR. The monopolist will find his equilibrium at a point where MC = MR and accordingly.A.f. F. (w. In case of increasing costs.B. Micro Economics. June 2007) 82 .Y. the physical out put shows decreasing returns. Constant costs are due to constant returns to scale. Increasing returns to scale leads to decreasing costs and decreasing returns to scale leads to increasing costs.Ranga Sai Monopolist under different Cost Conditions Changing cost conditions are determined by changing returns to scale.

The price is determined as per AR. Long run equilibrium under monopoly Micro Economics. The monopolist will find his equilibrium at a point where MC = MR and accordingly. the out put is determined. In case of decreasing costs. AC and MC curves will be downward sloping.f.A.Ranga Sai In case of constant costs. (w. the physical out put shows proportional returns.Dr. AC and MC curves will same and horizontal. The monopolist will find his equilibrium at a point where MC = MR and accordingly.e.Y. June 2007) 83 . the physical out put shows increasing returns.B. F. the out put is determined. The price is determined as per AR.

OR Determine price P2 price with larger output Q2 and optimize the cost by producing at minimum AC in the long run. In this case the monopolist will have super normal profits. There are certain conditions to be fulfilled for practice of price discrimination. Discriminative Pricing Price discrimination means the firm selling the same product in different markets at the same time at different prices.f. At the equilibrium the monopolist can Determine price P1 by restricting the out put at Q1.Ranga Sai In the long run the monopolist will find his equilibrium at a point where MR (Long run) = MC (Long run) In the long run the AC curve becomes flatter an the firm will be able to produce more out put at lesser cost. F. The objective of price discrimination is profit maximization.Dr.Y. Price discrimination is possible only under the following conditions 1. Price discrimination is generally followed by a monopolist.A. June 2007) 84 . Legal sanction Micro Economics.B. Price discrimination is not always possible.e. In this case the monopolist will have normal profits. (w.

Dr.Ranga Sai

The practice of price discrimination shall be accepted by the law. In absence of legal sanction price discrimination will be called cheating. 2. Geographically distant markets The markets with different pieces shall be geographically far. The markets should be far enough to prevent resale of goods. 3. No possibility of resale Resale should be prohibited. In case of resale the monopoly profits will be drained out by those reselling the goods. 4. No storage possible Resale is not possible only I those goods whether storage is not possible. 5. Apparent product differentiation The firm shall follow apparent product differentiation. In such cases the buyers will find justification for paying a different price. 6. Let go attitude of the consumer The consumers should have a let go attitude. In case of consumer resistance, price discrimination is not possible. 7. Difference in elasticities of demand Difference in elasticities is an essential condition for price discrimination. There will be as many sub markets as the differences in elasticities.

In an elastic market, the firm can not charge higher price. Any increase in price will greatly decrease quantity demanded. So the price tends to be low. In an inelastic market, the quantity is not sensitive to price, so the firm will charge a higher price. The inelastic market: Market A has higher price and lower out put. The elastic market; Market B has lower price and higher out put

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Equilibrium with price discrimination
Firstly, the market is divided into sub markets depending on the elasticity of demand. Each market will have a different elasticity of demand. Suppose the firm can divide the markets into two sub markets: market A an inelastic market and Market B - an elastic market.

1. Out put determination MC = Σ MR 2. Out put distribution Σ MR = MRa = MRb 3. Price determination The prices are determined as per ARs. Though the markets are different, the place of production is centralized. The firm will produce at a single place. Depending on the component markets, the aggregate market is constructed. The firm will determine the equilibrium out put; this is the out put which will be distributed among different markets. The firm will consider the aggregate MR i.e. Σ MR for determining the equilibrium. 1. Out put determination MC = Σ MR This is the optimum out put determined at the aggregate market. 2. Out put distribution Σ MR = MRa = MRb

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The out put is distributed in different markets by equating Marginal revenues. The equilibrium level of MR is passed over to different markets, this way the equilibrium is created in sub markets. The equilibrium level of MR will indicate the out put in different markets. 3. Price determination The prices are determined in different markets as per the Average revenues (demand) in different markets. It can be seen that the The inelastic market: The elastic market:

Market A has higher price and lower out put. Market B has lower price and higher out put

Dumping
Dumping is a special case of price discrimination where the firm is a monopolist in the home market and faces competition in the foreign market. In the home market the firm faces a downward sloping (demand) AR curve whereas in the foreign market the AR curve is perfectly elastic with AR=MR=Price relation.

The firm firstly, determines the out put to be produced for the local as well as the foreign markets. There after, the out put needs to be distributed among home and foreign markets. Finally, the price is determined. 1. Out put determination MC = MR ( maximum possible MR) 2. Out put distribution MRh = MRf 3. Price determination
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e. June 2007) 88 . the out put is restricted so as to charge a higher price.B.e. Under perfect competition the firm being a price taker has a perfectly elastic AR demand curve. F. Comparison between Imperfect and perfect competitions A comparison between perfectly competitive firm and that of imperfect competition shows that there are differences in the methods of out put and price determination. The out put is distributed by equating MRs in different markets.A. The remaining out put is sold in the foreign market at the price prevailing as per AR=MR=Price. While pricing on the down ward sloping AR. Both firms determine the out put at a point where MC = MR. It can be seen that the firm sells a small out put in the home market at high price and a large out put in the foreign market at low price. With perfectly elastic AR curve the competitive firm produces more than the monopolist. Price determination A firm determines price as per the AR curve. The out put is determined by equating MC=MR..Ranga Sai The prices are determined as per AR in the home market and at the existing price at the foreign market.Dr. i. Out put determination The out put under imperfect competition is lesser than the competitive output. MRf = MRh At this point the out put is allotted for home market and he price is determined as per the downward sloping demand curve. Micro Economics.Y. The monopolist determined price on a down ward sloping demand curve.f. (w. The monopolist charges price as per the down ward sloping demand AR curve. By restricting the out put the firm can charge higher price. This is the profit maximizing out put. So by restricting out put the monopolist can charge a higher price. This is called dumping.

Module 8: Monopolistic competition and oligopoly Monopolistic Competition Monopolistic competition is a case of imperfect competition where limited number of firms. It is a large market where firms compete. The AR being high at the equilibrium out put the firm charges higher price. Large number of buyers: The number of buyers is large. but competition discourages new firms. The entry is not restricted by law. Monopolist firm is exploitative as compared with a competitive firm.A.Dr.e.Y.Ranga Sai The price monopolistic competition is higher than the competitive price. compete with differentiated product at dissimilar prices. 2. F.B. Following are the features of monopolistic competition: 1. June 2007) 89 . Micro Economics. Limited number of firms: The number of firms remains limited due to intense competition.f. (w. In both these case.

The firms charging different prices justify their prices by advertising. (w. Each firm produces goods as per their own market. In such a case the prices also differ. Selling cost does not give utility. so the product quality. Product differentiation Product differentiation means the same product being projected different. publicity. Product differentiation means differences in cost. The product differentiation is done in flowing ways: a. Firms sell at different prices. Additional quality: The product can be designed with an additional utility. 5. Selling cost Selling cost is the cost of generating demand. b. It is seen that dual utilities have improved the quality of the product like the two-in-one products. Under monopolistic competition.e.B. the firms engage in non price competition.Ranga Sai 3. The prices need not be uniform.Dr. The firms justify the price by either different image/ brand equity or by different qualities/utility of the product. 4. c. field campaign and similar promotional activities. The objective of price differentiation is to claim monopoly power in an imperfect market.f. Selling cost is a burden on the consumer. F. by modifying with additional utility. With differences in cost the price also changes. The quality should be such that the utility of the product gets enhanced. Etc. The consumer is made to pay higher pries which are falsely justified through advertising. Non-price competition benefits the firms. brand image and justifying the price. prices. The competition between firms with different prices is called non-price competition. quizzes. Products with different utilities have elastic and larger demand.A. Micro Economics. It may be by way of guarantees. This is one method of improving the appeal of the product. By different term of sale: the fir may offer a different terms of sale. By an additional quality: the firm may show a different quality of the product which may not exist in the market. contests. utility differ. after sale service. June 2007) 90 .Y. quality or term of sale. Selling cot helps in generating demand. This is done by creating unique selling proposition.

Selling cost makes demand elastic and shifts demand curve u wards. In the diagram it can be seen that. Whereas. The production cost decreases with increasing out put in. Short run Equilibrium under Monopolistic Competition A firm under monopoly competition arrives at equilibrium like a monopoly firm. proportion. However the optimizing condition for out put remains same as in case of perfect competition. Yet.e. When Micro Economics.Dr. the selling cost increases in larger proportions to increasing out put. so the AR and MR curves also slope down wards and look different. This is because.Y. with increasing out put. the demand curve has shifted upwards and also became elastic. (w. F.A.Ranga Sai Production cost on the other hand generates utility. This is the advantage the firm receives by spending selling cost. This is due to economies of scale. selling cot has increased the average cost.B. June 2007) 91 .f. At a point where MC = MR the firm finds its equilibrium out put. For a firm. the demand curve is downward sloping. advertising becomes more and more expensive.

e. In case of loss there is a need for further analysis. This is the demand curve which will tell the maximum price that can be charged for this level of out put. Maximum bearable loss: Micro Economics.A. The firm needs to decide whether to stay in production or shut down.f.Dr. Profits: A firm is said to be making supernormal profits if AR > AC. June 2007) 92 .Ranga Sai MC = MR the difference between TC and TR will be maximum. In such a case Average variable cost (AVC) is considered. The price determination is done by AR curve. The output is found on the x axis.B. Losses: A firm is said to be making losses if. The price charged by the firm covers all the costs and also generates a surplus over the expenditure. In this case the firm receives the managers’ remuneration (normal profits) and also a surplus over it. F. (w. Hence it is called super normal profits.Y. AR < AC.

B. the firm needs to close down. The price received fails to cover fixed cost as well as a part of variable cost. (w. the firm can reduce losses by closing down.f. So if the firm closes down the loss is equal to fixed cost.Y. June 2007) 93 . F. This is called Shut down condition.Dr.e. So. If the firm continues to produce the loss will be fixed cost and a part of variable cost.Ranga Sai Shut down Condition If AR < AVC. Micro Economics.A.

Ranga Sai Long run equilibrium under monopolistic competition There is free entry and exit of firms under monopolistic competition. So in the long run. With new firms joining the super normal profits.A. In the long run the perfect competition has only firm which operate on normal profits. At this point AR = MR = AC. In the long run the equilibrium is drawn at a point where LMC = MR. where AC = AR is a condition of normal profits. It means the firm covers only the manager’s remuneration and there is no surplus over and above this. When there is free entry and exit of firms.e. June 2007) 94 .B. At the same time when the profits decrease the less efficient firms leave the industry. efficient firms which can operate at normal profits only exist. (w. F. imperfect competition. get distributed among more and more firms.f. the firms keep joining the production as long as there are profits.Y.Dr. Wastages in Monopolistic competition A comparison between perfectly competitive firm and that of imperfect competition shows that there are wastages and exploitation under. In he ling run all firm will operate at normal profits. Micro Economics.

June 2007) 95 . 4. Advertising leads to increases in cost and dos not yield any utility to the consumer. In the process it produces less than optimum size of out put. Imperfect competition leads to less than optimum size of out put: The monopoly firm restricts the out put so that it can realize higher price. (w.e. 2. Monopolistic competition has wasteful advertising. 3.A. In case of perfect competition the prices are low and uniform.Ranga Sai 1. The price monopolistic competition is higher than the competitive price. The out put under imperfect competition is lesser than the competitive output. The firm will be producing at higher cost.Y. F. Imperfect competition will lead to unfair competition. Non price competition leads to price exploitation of consumers.f. but the price charged. The AR being high at the equilibrium out put the firm charges higher price. will be much higher granting larger profits to the monopoly firm.Dr.B. Micro Economics. 5. Under non price competition the firms sell goods at different price and justify higher price by advertising. By restricting the out put the firm can charge higher price.

There will be huge market for which the firms compete. High degree of interdependence between firms The firms will have high degree of interdependence in terms of price and product design. F. similar product details and advertising. Micro Economics. Following are the features of oligopoly market 1.B. The demand remains very flimsy for a firm.f.Dr.A. Rigid and uniform prices The price will remain uniform and rigid. The firms almost share the same demand curve. (w. A consumer will not pay a higher price because he can continue to get the same price from other firms. This is called as price illusion. Large number of buyers The number of buyers will be very large. Further. 2. No firm can deviate and change the product description. Advertising is essential for registering the product with the consumer. Any change made by the firm will lead to the consumer shifting to other competing firms. The industry remains as a small group of firms. June 2007) 96 . 3. On the other hand reduction in the price may be treated as a loss of quality. Limited number of firms: The number of firms is limited due to intense competition. it continues for a long time.e.Ranga Sai Oligopoly Oligopoly is an imperfect market condition identified with limited number of firms with high interdependence competing with differentiated or uniform product at uniform prices. advertising make the demand elastic. the demand is made elastic or remains inelastic depending on the nature of advertising. the firm will be able to sell more goods at the given price. By making the demand elastic.Y. 5. 4. The demand is maintained carefully by maintaining the same price. However. Advertising Advertising is an essential part of oligopoly market. Advertising allows the product to have the required exposure to the consumer so that the consumer can include the product in his options. A firm will not reduce the price because the consumer is willing to pay the given price. When the price is accepted by the firms and the buyers.

In a cartel. 7. (w.e.A. a. the firms with high price may insist that its price prevail.Y. enter into agreements to lessen competition and share the market to exploit the consumers. price and market share. Collusive and Non collusive oligopoly Non collusive oligopoly refers to a market where the forms operate independently. Pure and differentiated oligopoly Pure oligopoly deals with goods are homogenous whereas differentiated oligopoly may have apparent product differentiation. price and the nature of competition. The leader will have the advantage of giving a lead price to the product which other firma will follow. Pure oligopoly may at times change to partial oligopoly by frequent mergers. Types of oligopoly There are different types of oligopoly each based in a different marketing practices followed to manage competition. c. the price tends to change because of cost variations. Cartels Cartels are a case of collusive oligopoly. Firms in market with intense competition form arrangements to avoid competition by making agreements so that all firms tend to benefit at the cot of the consumer. At the same time the firm with lesser price may insist on its price to be followed so that larger out put can be sold. In case of collusive oligopoly. Complete and partial oligopoly Complete oligopoly refers to market where all the firms are equally placed in terms of competition. Cartels are harmful business organization formed to enhance exploitation and increase profits. there can be one large firm emerging as the leader. June 2007) 97 .Ranga Sai 6. The leadership firm will have the privilege of designing the product. Firms merge among themselves to form a large firm so that a leadership role can be achieved. Even in theses conditions the firms need to maintain the uniform prices. b. a. F. so that all firms can maximize profits. In ace of pure oligopoly it is easy to maintain price uniformity. b.Dr.B. The market offers flexibility the firms to change the nature of the product keeping the base utility same. With product differentiation. There can be different types of cartels depending on agreements. For this reasons the firma can only adopt apparent product differentiation without changing the cost structure. however with interdependence. Whereas in case of partial oligopoly. the firms may collide.f. Micro Economics.

The demand remains very flimsy for a firm. There will be huge market for which the firms compete. Any change made by the firm will lead to the consumer shifting to other competing firm. Single firm can deviate and change the product description. Following are the feature of a model duopoly market: 1. High degree of interdependence between firms The two firms will have high degree of interdependence in terms of price and product design. similar product details and advertising. (w.A.Ranga Sai These are price cartels. However. Hence it is a model of oligopoly. All these agreements where the firms or the counties get captive markets belong to cartels. where the regions are shared on the basis of trading currencies or countries.e.Y. The firms may divide the market geographically and restrict mutual entry in respective territory. The cartels can be operating at international levels. and multilateral agreements for a specific time. c.Dr. Micro Economics. 3. the demand is made elastic or remains inelastic depending on the nature of advertising. Duopoly Duopoly is a model of oligopoly market with two firms designed to study the interdependence of firms for pricing. d. The demand is maintained carefully by maintaining the same price. 2. Large number of buyers The number of buyers will be very large. Two firms: The number of firms is limited to two.f. In both these cases competition is avoided and market becomes lucid. In this case the market has one monopoly firm selling the product. bilateral agreements. The counter may form commodity agreements.B. A firm operating in market as an exclusive monopolist may have to pay market royalty to other firms restricting entry. This is for the purpose of studying the details of interdependence. Two firms almost share the same demand curve. F. The firms may have system of marketing royalties as consideration for sharing territory for attaining monopoly power. June 2007) 98 .

By making the demand elastic. 5. Yet the firms will have demand curves with different elasticities. Rigid and uniform prices The price will remain uniform and rigid. (w.B.e. Micro Economics. The demand curve for the market is made up of these tow demand curves. This is called as price illusion. it continues for a long time. The inelastic segment of the demand curve at lower price s and the elastic segment of demand curve ay higher prices form the segmented demand curve in duopoly.Dr. Kinky demand curve The demand curve for the duopoly market is med up of the individual demand curves of two forms. Further. the firm will be able to sell more goods at the given price. 6. Advertising allows the product to have the required exposure to the consumer so that the consumer can include the product in his options. A firm will not reduce the price because the consumer is willing to pay the given price. Advertising is essential for registering the product with the consumer.Ranga Sai 4.f. These are the demand curves made by the firms by the independent advertising campaigns and publicity. June 2007) 99 . A consumer will not pay a higher price because he can continue to get the same price from other firm. On the other hand reduction in the price may be treated as a loss of quality. advertising make the demand elastic.Y. When the price is accepted by both the firms and the buyers. F.A. Advertising Advertising is an essential part of oligopoly market.

P is the uniform and rigid price followed by firms under duopoly. (w. P is the point which is common on both the demand curves.A.B.Dr.f. June 2007) 100 . This is the price which can be followed on both the firms. The firms will be operating on the segmented demand curve which forms a kink at P. F.e.Y. (19006)5-05-2010 Micro Economics.Ranga Sai It is learn in point elasticity of demand that all goods tend to be elastic at higher prices and inelastic at lower prices.

First Year Micro Economics First Year B. vazecollege.Com Banking and Insurance I Semester Macro Economics First Year B.M.Y.e.Com First Year B.com and www.f.M.Dr.Com Third Year B. F.Com Second Year B.B.net Micro Economics.Ranga Sai Other books in this series Business Economics Paper I Business Economics Paper II Business Economics Paper III Introduction to Economics B.Com Accounting and Finance I Semester First Year B. June 2007) 101 . (w.Com Banking and Insurance II Semester Second Year BCom Accounting and Finance IIISemester Based on University of Mumbai curriculum Available for free and private circulation At www.A. rangasai.

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