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INTRODUCTORY MICROECONOMICS

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1.1 Central Problems of an Economy 1.2 Production Possibility Curve and Opportunity Cost 1.3 Micro versus Macro Economics

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

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Unfortunately, this may be true only in heaven, not in the real world. Even the richest person on earth would have to face scarcity and make choice. If nothing else, time is scarce. Ratan Tata, a leading industrialist of India, between 6 p.m. and 8 p.m. in a particular evening, may have to decide whether to go to a musical concert, or just keep working in his office. Think about the length of syllabi of various subjects that you have to cover before the final exam. We do not need to convince you that time is scarce. Likewise, food, clothing, housing, clean air, drinkable water etc. are scarce in every country in the world, except that the degree of scarcity varies. The point is that problems of choice arise because of scarcity. The study of such choice problems, at the individual, social, national and international level is what economics is about. 1.1 CENTRAL PROBLEMS OF AN ECONOMY: WHAT, HOW AND FOR WHOM There are many choice problems that any particular economy attempts to solve within a given time period. For example, during the fiscal year 1998-99, 71.3 million tons of wheat was produced in India.1 Output of food grains in general is not entirely determined by external factors like
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rainfall etc. It is partly influenced by how much of land is used to raise food grains, by the application of fertilisers, by the supply of power to agricultural sector etc. And these are consequences of individual choice as well as policies by the government. Thus Indias wheat production in a given year is, partly, an outcome of choice. India, as many other countries, does not produce jet planes. But it produces helicopters, small air-crafts for training purposes as well as some fighter planes. 2 This also reflects a choice problem.3 Not only what goods a nation should produce is a problem of choice, so is how or in which method a good is to be produced. Usually, there is more than one method to produce a given commodity. For example, agricultural activity is more labour -intensive in India than in developed countries like US, France or Germany. Who is paid how much is also a choice problem from the economys viewpoint. There are differences in pay or salary across occupations. For instance, in the latter half of 1990s the beginning salary (including allowances) for a Class I government servant was between Rs. 1.5 lakhs to Rs. 2 lakhs per annum. In comparison, on the average, a computer programmer in

The source is Ministry of Finance, Government of India, Economic Survey 2000-2001, published in 2001. These are produced by Hindustan Aeronautics Limited (HAL). We recommend you to visit its website: www.hal-india.com. It contains pictures and brief descriptions of different aircrafts produced by HAL. You may argue that India does not produce jet planes because it does not have the necessary technology. However, having a technology or not can be seen as a choice problem. Many technologies can be purchased if we decide to pay for it. But we do not and should not buy any available technology even if we can afford it. We have to weigh the benefits from having a technology against the cost of acquiring it.

INTRODUCTORY MICROECONOMICS

India was receiving Rs. 2.58 lakhs per annum in 1999.4 Various economic problems facing an economy can be categorised into three types. These are the so-called what, how and for whom problems. They arise due to scarcity. What to be: What goods and services are produced and in what quantities? For example, in the fiscal year 199798, the Indian economy produced 82.1 million tons of cement. Why is it 82.1 million tons, not 40 million tons? In the same year India produced 9.8 million bicycles.5 What factors determine these quantities? And so on.6 How to be: How (i.e. by which methods) would the goods and services be produced? Should garments in India be produced by relatively labour intensive or machine-intensive methods? What techniques of production are to be used? For whom to be: Given that various goods and services are available to an economy, who gets how much to consume? This essentially refers to who earns how much or who has more assets than others. For example, how much a computer engineer consumes is based on his earnings compared to a chemical engineer or a high-school teacher? This is the for whom question. It refers to distribution of income and wealth in the society.
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In a market-oriented or capitalist economy, these fundamental problems are solved by the market. There is a price, which is influenced by the forces of demand and supply. These forces guide which goods and how much is to be produced and consumed. For example, alu bhujia is produced in the Indian economy because the technology of making alu bhujia is available, the cost of producing and supplying it is not too high and there is demand for alu bhujia. This illustrates how the what problem is solved in a market-oriented economy. Suppose that the oil production in the world market declines drastically for some reason. This will increase the price of diesel and petrol world-wide. A taxi company in Ludhiana, which was running 10 taxis, will now wish to convert some of them to CNG (compressed natural gas). In other words, the method of production of taxi service will change. This example illustrates how the how problem is solved. As another example, if there is an increase in demand for computer hardware and software by businesses and households, this will push up the demand for services by computer engineers. As a result, their salaries (prices) would increase. These

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See Ed.Frauenheim, India Inc., TechWeek, September 20, 1999 (also see http://www.techweek.com). This salary figure, stated in US dollars, is $6,000. At the 1999 dollar-rupee exchange rate of $1 = Rs. 43, it becomes Rs. 2.58 lakhs. The source is Economic Survey 2000-2001, Ministry of Finance, Govt. of India, 2001. These are examples of goods or commodities that have physical dimensions. Services refer to tasks being performed for someone, e.g., a hair-cut, education, doctors advice etc. What problem applies to services as well.

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

Alternatively, in a centrally planned economic system, which was in practice in the former Soviet Union and other East European countries till the late 1980s, these problems are addressed in a very direct way by the government. See Clip 1-1 for details.7 Clip 1-2 provides an account of the demerits of a central planning system relative to a capitalist system.

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

INTRODUCTORY MICROECONOMICS

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

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

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

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

Table 1.1 Production Possibilities Production of Cricket Bats Production of Saris (in thousands) (in lakhs) Possibility A Possibility B Possibility C Possibility D Possibility E Possibility F
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75 70 62 50 30 0

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

INTRODUCTORY MICROECONOMICS

PPC shows the maximum amount that can be produced of one good, given the amount produced of the other good. A

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

(b) Fig. 1.1 Production Possibility Curve

PPC is downward sloping, because more production of one good is associated with less of the other.9 Note that the PPC does not show or say which point the economy will actually operate on. It only shows the possibilities. The economy may not be even operating on the curve. For example, if there is unemployment (as true for a country like
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We already know that, along a PPC, more production of one good means some sacrifice of the other good. The rate of this sacrifice is called the marginal opportunity cost of the expanding good. Go back to Table 1.1. Starting from possibility B, if the production of cricket bats increases by one unit (to 2), 70 62 = 8 lakh saris need to be forgone. Hence, at the production possibility C, the marginal opportunity cost of cricket bats is equal to 8 lakh saris. Similarly, when 3 thousands bats are produced, the

The concept of downward sloping is explained in Appendix 1.

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

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

Marginal Opportunity Cost along the PPC Production of Saris (in lakhs) 75 70 62 50 30 0 Marginal Opportunity Cost of Bats (in saris) 5 8 12 20 30

Production of Cricket Bats (in thousands) 0 1 2 3 4 5

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

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

Fig. 1.2

Shift of the PPC

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

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

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On the other hand, macro economics deals with the behaviour of aggregates such as real Gross Domestic Product (GDP), employment, inflation etc. What determines the real GDP or inflation rate

in an economy? What policies can reduce the rate of unemployment in a developing country like India? And so on. This book is designed to cover some basic principles of microeconomics.

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

* We need not mention NET in every clip.

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SUMMARY
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Economics is a social science. Economics is concerned with the study of individual and social choice in situations of scarcity. There are three central problems facing any economy, namely, what, how and for whom. The what problem refers to which goods and services will be produced in an economy and in what quantities. The how problem refers to the choice of methods of production of goods and services. The for whom problem concerns with the distribution of income and wealth. In a capitalist or market-oriented economy, these problems are addressed through the operation of markets. Normally, the production possibility curve is concave to the origin. It is because of increasing marginal opportunity cost. A production possibility curve shifts out due to technological progress or increases in the supply of resources available to an economy or both.

EXERCISES

Section I
1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 What is economics about? Name any two central problems facing an economy. Define the production possibility curve. Define marginal opportunity cost along a PPC. What does increasing marginal opportunity cost along a PPC mean? Define opportunity cost. What is microeconomics? What is macroeconomics?

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Section II
1.9 1.10 1.11 1.12 1.13 1.14 1.15 1.16 1.17 Explain how scarcity and choice go together. Economics is about making choices in the presence of scarcity. Explain. What are the central problems of an economy and why do they arise? Explain any two central problems facing an economy. Explain the central problem of what with examples. Explain the central problem of how with examples. Explain the central problem of for whom with examples. Why does the PPC look concave to the origin? An economy produces two goods: T-shirts and cell phones. The following table summarises its production possibilities. Calculate the marginal opportunity costs of T-shirts at various combinations. T-shirts (in millions) 0 1 2 3 4 5 1.18 1.19 Cell phones (in thousands) 90,000 80,000 68,000 52,000 34,000 10,000

Draw the production possibility curve for the example of Mr. Kheti Lal in the text. Suppose you have to practice question-answers for two subjects: mathematics and social science. You have 8 hours to study. You are very good at answering multiple choice questions in mathematics: 20 questions per hour, while you are not that good in answering such questions in social science: 12 questions per hour. Derive your production possibility schedule and plot it. (The two goods here are (i) mathematics questions practised and (ii) social science questions practised.)

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1.20 1.21 1.22 1.23

1.24 1.25 1.26 1.27 1.28

1.29

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

Section III
1.30 A country produces two goods: green chilli and sugar. Its production possibilities are shown in the following table. Plot the PPC in a graph paper and verify that it is concave to the origin. What is the pattern in the table that gives rise to the concave shape of the PPC? Green Chilli Possibility A Possibility B Possibility C Possibility D Possibility E Possibility F 100 95 85 70 50 25 Sugar 0 1 2 3 4 5

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CONSUMER BEHAVIOUR DEMAND
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CHAPTER

CONSUMER CHOICE AND THE DEMAND CURVE



In Chapter 1 it was stated that, in a marketoriented economy, the central problems of what, how and for whom are solved through forces of demand and supply for various goods and services. Who demands a particular good and who supplies it? This depends on the type of good or service in question. Consider a final product such as alu bhujia.1 As consumers, households are the demanders of alu bhujia and companies like Bikanerwala and Leher are the suppliers. Another example is the service of a computer programmer. This service is demanded by companies or firms. Who are the suppliers of this service? The households, because some members of some households work as computer programmers. In summary, in case of final goods and services, households demand them and firms supply them. In case of services that are required for production, households are the
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2.1 Consumer's Equilibrium 2.2 Meaning and Determinants of Demand 2.3 Market Demand Curve 2.4 Price Elasticity of Demand

Final goods and services include things that are consumed by households, e.g. a piece of bread, a haircut, a bicycle repair job etc. As opposed to final goods and services, there are intermediate goods (or raw materials) that are consumed (i.e. used up) by businesses. The examples are steel in a bicycle factory, wheat in a flour mill, and various automobile components in a Maruti car workshop.

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suppliers and the fir ms are the demanders. This chapter deals with households as consumers and their demand for final goods and services. How should a consumer decide how much of a product to buy? What factors do affect this decision and how? 2.1 CONSUMERS EQUILIBRIUM: THE BASIS OF THE LAW OF DEMAND Let us ignore for the moment the word equilibrium or the phrase Law of Demand, and focus on the question of how much of any particular good a consumer should demand (or buy) at a given point of time. In order to understand this, we first have to learn a few concepts. 2.1.1 Utility Concepts We begin with the notion that a consumer derives some satisfaction from consuming a product; otherwise, she would not demand it at all. This is captured by a term called total utility, defined as the total psychological satisfaction a consumer obtains from consuming a given amount of a particular good. Consider for example your consumption of gol guppa - the mouth-watering small round-shaped puffed puris, served with tamarind (imli) water and fillings.1 Imagine that you are hungry and have come to your favourite gol guppa vendor. Suppose that if you consume only one gol guppa you derive 20 units of pleasure or utility measured in some units. Let this (psychological)
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unit be called utils. Thus, the total utility from consuming one gol guppa is 20 utils. Suppose that you like gol guppa so much that eating just one increases your appetite for it. Let the second unit give an additional utility of 22 utils. Then, the total utility from consuming two gol guppas is 20+ 22 = 42 utils. In the same manner we can calculate total utility from consuming three, four or five units and so on. Besides total utility, there is another important concept called marginal utility, defined as the utility from the last unit consumed. Thus the marginal utility from consuming one gol guppa is 20 and that from consuming two gol guppas is 22. You can now notice the relationship that total utility is the sum of marginal utilities. Getting on with our story, your intensity of desire for gol guppa must fall, after consuming a certain amount, regardless of how much you like gol guppa. Suppose that, in your case, such decline in the intensity of desire starts with the third gol guppa you consume. Accordingly, let the third unit give you utility equal to a number less than 22, say, 18 utils. That is, the marginal utility and the total utility obtained from consuming three gol guppas are 18 and 42 +18 = 60 utils respectively. The next (fourth) unit gives you still less utility, say, 14 utils, and so on. This pattern of marginal utility is called the law of diminishing marginal utility. It states that, after consuming a certain amount of a good

Incase gol guppa is not known to the children, the teachers can use other popular eatable as example to explain the concept.

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or service, the marginal utility from it diminishes as more and more is consumed. If you think about it, this law is very natural and should hold for any product one consumes. In fact it is considered as a fundamental psychological law. You will see the critical role of it a little later. Let us resume our story once again. When you have already consumed quite a few gol guppas say 8, and you are very full in your stomach suppose that the next (9th) unit gives zero utility. Imagine what will happen if you keep gulping more. Suppose that eating the 10th unit makes you vomit! This is obviously not a pleasant experience and should give you negative satisfaction. Accordingly, let the utility associated Table 2.1 Units Consumed of Gol guppa 0 1 2 3 4 5 6 7 8 9 10

with the 10th unit be -7 utils. That is, the marginal utility of ten gol guppas is -7 utils. (If you are crazy and still eat more, each additional one can only give you more negative utility.) Table 2.1 summarises your experience with gol guppa in terms of marginal utility and total utility up to 10 units of consumption. Columns (2) and (3) present the marginal and total utility schedules. 2.1.2 How many Gol Guppas will you consume or buy?

From Table 2.1, it is clear that if you are a rational (not crazy) consumer, you will eat less than 10 gol guppas, since consuming 10 or more gives you negative marginal utility. If gol guppas

Marginal and Total Utility Marginal Utility (in utils) 20 22 18 14 11 8 4 2 0 -7 Total Utility (in utils) 0 20 42 60 74 85 93 97 99 99 92

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

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

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Table 2.2

Difference between Total Utility in Terms of Money and Total Expenditure Total Utility in terms of money (Rs.) 0 5 10.50 15 18.50 21.25 23.25 24.25 24.75 24.75 23 Total Expenditure (Rs.) 0 2 4 6 8 10 12 14 16 18 20 Difference (Rs.) 0 3 6.50 9 10.50 11.25 11.25 10.25 8.75 6.75 3

Amount Consumed of gol guppas 0 1 2 3 4 5 6 7 8 9 10

section is titled Consumers Equilibrium. The word equilibrium, frequently used in economics, means a position of rest. In this example, you will rest, stop or, as economists say, attain consumers equilibrium at 5 or 6 gol guppas. Because you do not want to consume less or more than these quantities. In general, we can then say that consumers equilibrium with respect to the purchase of one good is attained when the difference between total utility in terms of money and the total expenditure on it is maximised. 2.1.3 The General Principle From the example just worked out, we can now derive the general principle of

consumers equilibrium with respect to any particular good. Recall that one of our answers is 6 gol guppas. Ignoring the other answer for the moment, note that, at this level of consumption, the marginal utility in terms of money (Rs. 2) is equal to price (Rs. 2). This is indeed the principle and we can state this in two alternative ways. That is, the consumer s equilibrium is attained when
(A) Marginal Utility of a Product Marginal Utility of a Rupee = Its Price
(B ) Marginal Utility of a Product Its Price

Or

= Marginal Utility of a Rupee.

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

This forms the basis of defining demand for a particular good by a consumer: it is the quantity of the good that she is willing to buy at different prices within a given period of time. However, the price of a product is not the only factor that influences how much a consumer should buy of that product. For example, if there is a taste change, it will change the marginal utilities from a product, and, the consumers equilibrium condition will be fulfilled at some other level of consumption even when there is no change in price. Moreover, while our preceding analysis is confined to one good (e.g. gol guppa), in reality, a consumer buys many goods. The consumers equilibrium analysis with respect to many goods (which is outside our scope) suggests two other factors, namely, prices of related goods and income. This is quite natural. If a person consumes, for example, tea and coffee, then a change in the price of tea should affect her consumption of coffee and vice versa. Also, if income changes, different amounts can be bought even when the prices of goods and services she consumes remain unchanged. The last three factors just mentioned are called the determinants of demand. They are namely,

Nothing essential or important is gained by deviating from this assumption. The only modification is that, when a good is not perfectly divisible, the condition (A) or (B) holds either exactly or approximately.

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

The law of demand in tabular form is called a demand schedule. If we graph a demand schedule, we obtain a demand curve. It typically measures own price along the y-axis and quantity demanded on the x-axis. The demand curve corresponding to the demand schedule in Table 2.3 is shown in fig. 2.1. We see that the demand curve is downward sloping. It is because an increase in the own price lowers the Table 2.3 Own Price (in Rs.) 12 13 14 15 16 17 A Demand Schedule Quantity Demanded of Apples 24 17 12 9 7 6

quantity demanded. Each point of the demand curve shows the quantity demanded that is consistent with consumers equilibrium. Why is the Demand Curve Downward Sloping? Isnt it obvious that the demand curve is downward sloping? That is, as

Apart from (a), (b) and (c), there may be other determinants of demand for a good, e.g., future price expectation. Consider an essential product, say, edible oil or sugar. Suppose there is a weather prediction that your village or town will be hit by a severe cyclone in the next three days. You would then anticipate that supply interruptions would occur and prices of these commodities would skyrocket. If you are a rational consumer, you would buy more of these commodities now (and store them) even if prices, income or tastes do not change. Moreover, taste changes can occur not only because of natural changes in a persons liking, but also due to advertising of products.

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Table 2.4 Marginal Utility Schedule and the Demand Schedule Quantity of T-shirts 1 2 3
Fig. 2.1 Demand Curve Corresponding to Table 2.3

Marginal Utility of T-shirts 75 70 65 60 55 50 45

4 5 6 7

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

be restated as follows. The quantity demanded of T-shirts is 7 when the price is Rs. 45. Thus the pair (45, 7) will be on the demand curve. Similarly, suppose that the price of T -shirts increases to Rs. 65. The consumers equilibrium condition now holds at 3 T-shirts consumed, that is, at price Rs. 65, the quantity demanded is 3. Hence the pair (65, 3) will be on the demand curve too. Likewise, we can determine that all other points on the marginal utility schedule are points on the demand schedule. This means that the marginal utility curve itself is the demand curve, and, the demand curve is downward sloping because of the law of diminishing marginal utility.

An intuitive way to see this is that, as a consumer buys more of a good, her marginal utility decreases and therefore she is willing to pay less per unit. This can be turned around to say that if the price of a product falls, a consumer buys more of it.

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2.2.2

Determinants of Demand

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

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

Effect of an Increase in the Price of Coffee on Demand for Tea Quantity Demanded of Tea when Price of Coffee (per kg) = Rs. 200 20 11 5 2 1 Quantity Demanded of Tea when Price of Coffee (per kg) = Rs. 250 28 18 10 7 4

Price of Tea (per kg) Rs. 150 170 190 210 230

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Table 2.6

Effect of an Increase in the Price of Tea on Demand for Sugar Quantity Demanded of Sugar when Price of Tea (per kg) = Rs. 170 20 14 9 6 5 Quantity Demanded of Sugar when Price of Tea (per kg)= Rs. 200 12 7 4 2 1

Price of Sugar (per kg) Rs. 5 8 11 14 17

tea given in column (2) and (3) of Table 2.5 are graphed in Figure 2.2. We see that demand curve for tea when the price of coffee is Rs. 250 lies to the right of that when the price of coffee is Rs. 200. Hence, an increase (a decrease) in the price of a substitute good shifts the demand curve for a product to the right (left). Similarly, in Table 2.6, notice that, as the tea price increases from Rs. 170 to Rs. 200, the quantity demanded of sugar decreases for any given price of sugar. Figure 2.3 graphs Table 2.6. The demand curve for sugar when tea price is Rs. 200 lies to the left of that when the sugar price is Rs. 170. Thus, an increase (a decrease) in the price of a complementary good shifts the demand curve for a product to the left (right). A Change in Income Suppose that you only buy peanuts and ice cream from your pocket money. Ice cream is your favourite but it is costly. You like peanuts much less, but

Fig. 2.2

Change in demand due to increase in the price of a substitute good

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

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buy more or less of a product. If she buys more (e.g. ice cream), then we say that the product in question is a normal

those, for which demand falls as income rises. Table 2.7 presents numerical examples of both normal and inferior goods. Observe that, at any given price, as income increases, quantity demanded of the normal good increases (by comparing columns (2)-(3)) and that of the inferior good decreases (by comparing columns (5)-(6)). These are graphed in figs. 2.4 and 2.5. The original demand curve for the normal good, when income is Rs. 300, is indicated by the line NN0 in fig. 2.4. This represents the column pair (1)-(2). The new demand curve, when income of Rs. 400, is marked by NN 1 that represents the column pair (1)-(3). Hence an increase in income shifts the demand curve to the right if the good is nor mal. For the inferior good, the demand curves are indicated by FF 0 (original) and FF 1 (new) in

Fig. 2.3 Change in demand due to increase in the price of a complementary good

good. If she buys less (e.g. peanuts), then we say that it is an inferior good. Put differently, nor mal goods are those, for which demand increases as income increases. Inferior goods are Table 2.7 Own Price

Normal and Inferior Goods An Inferior Good Own Price Quantity Quantity Demanded: Demanded: Income = Income = Rs. 300 Rs. 400 3 4 5 6 7 8 20 17 14 11 8 5 15 12 9 6 3 0

A Normal Good (Quantity (Quantity Demanded: Demanded: Income = Income = Rs. 300 Rs. 400 15 12 9 7 5 3 19 16 13 11 9 7

1 2 3 4 5 6

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fig. 2.5. Thus an increase in income shifts the demand curve to the left if the good is inferior. In the real world, there are much fewer examples of inferior goods than normal goods. Yet there are important examples. In India, cereals as a single category of goods (that includes rice, wheat, bajra, jowar etc.) constitute an inferior good. Within this category, the inferior-good characteristic applies to bajra, jowar, maize and related cereals. A Change in Tastes Finally, consider a taste change. Suppose you are impressed by an advertisement in TV, in which your favourite actor drinks Coca Cola, and, as a result, your liking for Coca Cola increases. This will shift your demand curve for Coca Cola to the right. This is an example of a favourable change in tastes. An unfavourable change in taste will imply the opposite. We can then say
Fig. 2.5 Change in demand due to increase in income (Inferior Good)

that a favourable (an unfavourable) change in tastes shifts the demand curve to the right (left). A taste change may result from a change in a persons liking, or, from some other source. If, for instance, for health reasons, you have to consume more of a product although you dont like it, this is also considered a taste change. 2.2.3 Change in Quantity Demanded Versus Change/ Shift in Demand We have seen that the quantity demanded of a product depends on own price and other factors like prices of related goods, income and tastes. The law of demand refers to the effect of a change in the own price. A graphical representation of this is the demand curve, which is downward sloping. A change in the own price causes a movement along a given demand curve: higher (lower) the price, less (more) is the quantity demanded.

Fig. 2.4 Change in demand due to increase in income (Normal Good)

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Such a movement is called a change in the quantity demanded. In contrast, when a change in any other factor causes a (left or rightward) shift of a demand curve, we call this a change in demand. The distinction between the two concepts is illustrated in fig. 2.6. Fig. 2.6(a) illustrates a change in the quantity demanded. There is a price change from P0 to P1. As a result, there is a movement along the same demand curve from A to B. The quantity demanded changes from Q0 to Q1. In contrast, fig. 2.6(b) shows a change in demand, meaning a shift of a demand curve from DD0 to DD1 due to a change in the prices of related goods, income or tastes. 2.3 MARKET DEMAND CURVE We have studied consumers equilibrium and the determinants of demand for a good from the perspective of a single individual. How do we get the demand curve of a product by all individuals together in an economy, e.g., the economy of a region or a country? The economy-wide demand curve for a particular product is called the market demand curve. It is obtained by summing up the demand curves across consumers or households. Consider the market for, say, gulab jamun. Suppose that there are three consumers in the market: Amar, Akbar and Anthony. If at the price equal to Rs. 3 a piece, Amar demands 5, Akbar 6 and Anthony 8 per week, then the total quantity demanded is 19. Hence

(a) Change in Quantity Demanded

(b) Change in Demand Fig. 2.6 Change in Quantity Demanded Versus Change in Demand

(3, 19) is a point on the market demand curve. Repeat the same exercise for other possible prices and obtain the corresponding points. Plot the points, join them and you get the market demand curve. A numerical example is given in Table 2.8. Individual demand schedules are given by column pairs (1)-(2), (1)-(3) and (1)-(4). The column

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pair (1)-(5) gives the market demand schedule. Note that for each row (price), the entry in column (5) is the sum of corresponding entries in columns (2), (3) and (4). These individual demand schedules and the market demand schedule are graphed in fig. 2.7. Amars, Akbars and Anthonys demand curves are respectively marked by their names. The right most line is the market demand curve. This is obtained by horizontally summing the individual demand curves. What are the determinants of the market demand curve? They are the determinants of the individual demand curve described earlier plus how many consumers buy the product, that is, (a) prices of related goods; (b) income levels across individuals, or Table 2.8

what we can call, the distribution of income; (c) consumers tastes (d) the number of consumers who buy the product, or what we can call, the market size.5 2.4 PRICE ELASTICITY DEMAND OF

We have seen how various factors like own price and income affect the demand for a commodity. The direction of change was our focus - whether the quantity demanded increases or decreases as price, income or other factors change. The concept of elasticity captures the magnitude of change or the degree of responsiveness. For example, the price elasticity of demand quantifies the effect of a change in own price on the quantity demanded.

Individual and Market Demand Schedules for Gulab Jamun Amars Demand 7 6 5 4 3 2 Akbars Demand 15 10 6 3 1 0 Anthonys Demand 13 10 8 7 6 5 Market Demand 35 26 19 14 10 7

Price of Gulab Jamun in Rs. 1 2 3 4 5 6


5

Many multinational firms today look at the Indian or the Chinese market as very lucrative, because of their market sizes, which refer to the huge number of consumers in these countries.

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Fig. 2.7 Individual and Market Demand Curves

2.4.1 Definition and Formulas Formally, Elasticity of demand is defined as


(C ) Price elasticity of demand = e D % change in the quantity demanded = % change in the own price

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

Along a given demand curve, let the original price be P0 and the original quantity be Q0. Suppose that the price increases to P 1 and the quantity demanded falls to Q1. Then the % changes in price and quantity demanded are respectively equal to [(P1P0)/P0]100 and [(Q1Q0)/Q0]100. Thus (C) can be written as

(D ) e D =

(Q1 Q0 ) / Q0 . (P1 P0 ) / P0

If we further denote a change in quantity as Q and a change in price as P, we can also write
(E ) eD = Q/Q0 . P / P0

Consider the following numerical example. Suppose that in your home town, rasgoolas were being available at Rs. 5.00 per piece and the residents of

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

D1D0 along DD). This implies that, while the % change in price is the same along both demand curves, the % change in quantity demanded is greater along DD. Therefore, price elasticity associated with DD is higher. 3. Higher the value of the price elasticity, greater is the degree of responsiveness of quantity demanded to price. In particular, if eD>1, then the % change in quantity demanded must exceed the % change in price. We then say that the product demand is elastic (e.g. jewellery). If eD<1, the % change in quantity demanded is less than that of the price, and, we say that the product demand is inelastic. Typically, the demand for luxury goods is elastic and that for necessary goods (e.g. basic food items) is inelastic. Finally, if eD =1, it is said that the demand is unitarily elastic. In this special case, the demand curve takes a particular

Fig. 2.8

Elasticity Comparison

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shape, called rectangular hyperbola in geometry. It is a curve, which extends towards the x-axis and y-axis in a uniform manner without touching them. Fig. 2.9 exhibits this. 4. There are two other special cases. If the product is absolutely essential, like demand for a rare medicine or some very bad case of addiction to undesirable products like opium, the demand curve is vertical. In this case, the price elasticity is zero, i.e., the product demand is totally or perfectly inelastic. This is evident, because, along a vertical demand curve, the quantity demanded is totally insensitive to any change in price. This case is exhibited in fig. 2.10(a). The last special case is the one, where demand curve is horizontal and thus the demand is perfectly elastic, i.e., the price

2.4.2 Factors Affecting the Magnitude of Price Elasticity In general, the magnitude of price elasticity depends on the following factors. Availability of Close Substitutes: If close substitutes of a product are readily available, its price elasticity of demand is likely to be high, because even a very small increase in price will make consumers switch to other

(a) Perfectly Inelastic Demand

Fig. 2.9

Unitarily Elastic Demand

elasticity is equal to infinity. Fig. 2.10(b) shows this. An economic example of this demand curve will be given in Chapter 4.

(b) Perfectly Elastic Demand

Fig. 2.10

Elasticitiy = 0,

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

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

Finding price elasticity of demand using its definition as such is called the percentage method of measuring elasticity. In particular, when the price change is very small, a graphical formula or a geometric method can also be used to measure elasticity. Suppose that it is a straight-line demand curve, as shown in fig. 2.11, having intercepts A and B respectively on the price axis and quantity axis

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Clip 2-1
Price Elasticity Estimates
Price elasticities have been estimated for various products and services and in the context of different countries. Five examples are reported below, four of which are for India and one for America. As you see, the price elasticities for food items and clothing are less than one, as these are essential items. Note that item No. 4 is an example of a service: long distance phone calls from PCOs. The elasticity for this item is also less than one. It indicates that long-distance telephone calls are not a luxury demand anymore; they have become a necessity in a country like India. The item no. 5 shows that the demand for residential land in America is elastic, equal to 1.64. Product/Service 1. Cereals & cereal substitutes (India) Other foods (India) Clothing (India) Long distance phone calls from Public Call Offices (India) Residential Land in Philadelphia (U.S.A.) Price Elasticity Estimate 0.544 Source Meenakshi and Ray (1999) Meenakshi and Ray (1999) Meenakshi and Ray (1999) Das and Srinivasan (1999)

2. 3. 4.

0.804 0.560 0.580

5.

1.640

Gyourko and Voith (2001)

Das, P. and P.V. Srinivasan, Demand for Telephone Usage in India, Information Economics and Policy, 11, 1999, pages 177-194. Meenakshi, J. V. and Ranjan Ray, Regional Differences in Indias Food Expenditure Pattern: A Complete Demand Systems Approach, Journal of International Development, 11, 1999, pages 47-74. Gyourko, J. and R. Voith, The Price Elasticity of Demand for Residential Land: Estimation and Some Implications for Urban Reform, mimeo, Wharton School of Management, 2001.

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

Fig. 2.11 Point Elasticity along a Straight Line Demand Curve

rasgoolas, does consumer spending or total expenditure on rasgoolas increase or decrease? By definition, the total expenditure on a particular good = price quantity. If we denote total expenditure by TE, price by P and quantity by Q, then TE = PQ. Let us now calculate TE. Originally, P and Q were respectively Rs. 5.00 and 1,200; hence TE was equal to Rs. 6,000. At the new price Rs. 5.50 and quantity = 960, TE = Rs. 5,280. Thus the total expenditure has fallen. Note also that the elasticity is equal to 2. That is, in the example, the demand for rasgoola is elastic, and, as there is a price increase, the total expenditure falls.

6 7 8

This is not a general property of price elasticity. It may not hold when the demand curve is not a straight line. At point B the elasticity is zero and at point A it is infinity. If it is not a straight-line demand curve, then the point elasticity measure at a point on it is based on the tangent to the curve at that point. You will find a treatment of this in a higher-level micro economics textbook.

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

scope. However, it is quite intuitive. If the demand for a product is elastic, it means that a small price change invites a relatively large adjustment in the quantity. Hence the total expenditure must change in the same direction in which the quantity changes. Now you see that, as price increases, quantity falls and the fall in quantity is associated with a fall in the total expenditure. Just the opposite holds when the product demand is inelastic. In this case a large price change leads only to a relatively small adjustment in quantity. Hence the total expenditure must change in the same direction as the price change, i.e., a price increase leads to an increase in total expenditure. So far we have discussed how we can determine the direction of change in total expenditure, given the direction of change in the price and given whether the product is elastic or inelastic. Alternatively, if we know the direction of change in price and the direction of change in total expenditure, we can infer whether the product demand is elastic or inelastic. For

Price Change and Its Effect on Total Expenditure Elasticity Total Expenditure

Price Change

eD > 1


No Change

eD > 1
eD < 1 eD < 1

eD = 1

CONSUMER CHOICE

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37

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

thinking about increasing the price of rasgoola, wouldnt you want to know if a price increase would increase or decrease your total sales in rupees? From a sellers perspective, the total value of sales is usually called total revenue and note that total revenue is equal to the total expenditure by the consumers.9 Hence the relationships between elasticity, price change and total expenditure are important from the viewpoint of decision making by a producer or a firm.

SUMMARY
l l l l l l l l l

Total utility is equal to the sum of marginal utilities. A rational consumer will never consume that much of a product such that the marginal utility from it is negative. At the consumers equilibrium, the difference between total utility in terms of money and the total expenditure on a good is maximised. Consumers equilibrium is attained when the condition that the marginal utility in terms of money is equal to the price is met. The law of demand defines demand curve, which is downward sloping. The demand curve is downward sloping because of the law of diminishing marginal utility. The demand curve is essentially same as the downward sloping portion of the marginal utility curve. A shift of the demand curve is caused by a change in the prices of related goods, a change in income or a change in tastes. An increase in the price of a substitute good causes an increase in demand or a rightward shift of the demand curve, while an increase in the price of a complementary good causes a decrease in demand or a leftward shift of the demand curve. As income increases, the demand for a product increases or decreases, i.e., the demand curve shifts to the right or left, depending on whether the good is normal or inferior.

We will see the use of the term total revenue in Chapters 4, 6 and 7.

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A favourable taste change increases the demand for a good, i.e., shifts the demand curve to the right; an unfavourable change does the opposite. Market demand curve is obtained by horizontally summing up the individual demand curves. The determinants of market demand curve are prices of related goods, distribution of income, tastes and the market size. The price elasticity of demand is independent of the choice of units. When two demand curves intersect, the elasticity associated with the flatter demand curve is greater. Greater the availability of close substitutes of a product, the higher is the price elasticity of demand for a product. Typically, the demand for luxury products is elastic and that for necessary goods is inelastic. Greater is the share of the total budget spent on a particular good, the more elastic is the demand for it. Longer the time horizon, the more elastic is the demand for a product. If the demand curve is vertical (horizontal), the price elasticity is zero (infinity). In case of elasticity equal to one, the demand curve is a rectangular hyperbola. Given that the demand is a straight line, the point elasticity is equal to the lower segment divided by upper segment of the demand curve at that point. If demand is elastic (inelastic), an increase in the price of the product leads to a decrease (an increase) in the total expenditure on the product. In case of a unitarily elastic demand, a change in price leaves the total expenditure on the product unchanged.

l l l l l l l l l

EXERCISES

Section I
2.1 2.2 Define total utility. Define marginal utility.

CONSUMER CHOICE

AND THE

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39

2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 2.11 2.12 2.13 2.14

How is total utility derived from marginal utilities? State the law of diminishing marginal utility. Give the meaning of demand. Name two determinants of the demand. List the factors that cause changes in demand. What is the law of demand? What is a demand schedule? Give an example of a pair of commodities that are substitutes of each other. Give an example of a pair of commodities such that one of them is complementary in consumption to the other. If the price of good X rises and it leads to an increase in demand for good Y, how are the two goods related? If the price of good X rises and this leads to a decrease in demand for good Y, how are the two goods related? Define price elasticity of demand.

Section II
2.15 A persons total utility schedule is given below. Derive her marginal utility schedule. Amount Consumed 0 1 2 3 4 5 2.16 Total Utility 0 10 25 38 48 55

A persons marginal utility schedule is given below. Derive her total utility schedule. (Assume that the total utility of consuming zero is zero.)

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Amount Consumed 1 2 3 4 5 6 2.17 2.18 2.19

Marginal Utility 7 10 8 6 3 0

2.20

2.21 2.22 2.23 2.24 2.25 2.26 2.27 2.28 2.29

2.30 2.31

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

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41

2.32 2.33 2.34 2.35 2.36

How does an increase in income affect the demand curve for an inferior good? Define (a) complementary goods, (b) substitute goods, (c) inferior good and (d) normal good. Distinguish between a change in quantity demanded and a change in demand. How is the market demand curve derived from the individual demand curves? There are four consumers of a fruit called Smile. They are Isha, Ifraah, Ila and Ibema. Their demand curves for Smile are given below. Derive the market demand curve. Quantity Quantity Quantity Demanded by Demanded by Demanded by Ifraah Ila Ibema 7 6 5 4 3 2 15 12 9 6 3 0 8 6 4 2 0 0

Price Quantity (Rs.) Demanded by Isha 1 2 3 4 5 6 16 11 7 4 2 1

2.37 2.38 2.39

2.40

2.41

Explain the determinants of the market demand curve. Distinguish between individual and market demand curves. Originally, a product was selling for Rs. 10 and the quantity demanded was 1000 units. The product price changes to Rs. 14 and as a result the quantity demanded changes to 500 units. Calculate the price elasticity. Which of the following commodities have inelastic demand? Salt, a particular brand of lipstick, medicine, mobile phone and school uniform. Draw diagrams showing elasticity equal to (a) zero, (b) one and (c) infinity.

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2.42 2.43 2.44 2.45 2.46

2.47

2.48

2.49 2.50

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

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43

2.51 2.52

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

Section III
2.53 Discuss how the market demand curve is derived from the individual demand curves and the determinants of market demand. Explain why consumers equilibrium is attained when the marginal utility of a product in terms of money is equal to its price. Suppose there are three consumers in a particular market: Leander, Andre and Tim. Their demand schedules are given in the following table.

2.54

2.55

Price Quantity Demanded Quantity Demanded Quantity Demanded by Leander by Andre by Tim 1 2 3 4 5 60 50 40 30 20 55 40 25 10 0 24 13 5 0 0

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2.56 2.57

(a) Derive the market demand schedule and plot the market demand curve. (b) Suppose Andre drops out of the market. Derive the new market demand curve. (c) Suppose Andre stays in the market and another person, Marat, joins the market, whose quantity demanded at any given price is half of that of Leander. Derive the new market demand curve. Why does the demand curve slope downwards? Explain the factors affecting the magnitude of price elasticity of demand.

PRODUCTION

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45

U N I T- I I I
PRODUCER BEHAVIOUR AND SUPPLY

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CHAPTER

3
AND

PRODUCTION

COSTS

3.1 Production

3.2 Costs

In Chapter 2 we studied the consumers behaviour. In Chapters 3 and 4 we will be concerned with the producers behaviour. In this chapter in particular, we study important concepts associated with production and costs. A producer or a firm is in business to maximise profit.1 By definition, profit earned by a firm is equal to its total revenues minus the total costs. As an example, suppose that you are in the business of making hammers, and, during a month, you produce and sell 500 hammers. They are selling at the price of Rs. 20 each. Then the total revenues generated are equal to price quantity, that is, Rs. 20 500 = Rs. 10,000. Producing hammers requires inputs such as labour, building, equipment and raw materials. This is a technological relationship. In turn, inputs have to be paid. The sum total of payments to all inputs is the total cost of production. Let the total cost of making 500 hammers over the month be Rs. 6,500. Then your profit is equal to Rs. 10,000 Rs. 6,500 = Rs. 3,500.

In this chapter and others, we will use the term profit or profits. Both are correct uses.

PRODUCTION

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47

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

output. In section 3.2, we will analyse that between output and payments to inputs. The link between output and revenues will be examined in Chapter 4 (and in Chapter 6 also). 3.1 PRODUCTION 3.1.1 Production Function The most basic concept here is what is called the production function, defined as a technological relationship that tells the maximum output producible from various combinations of inputs. For instance, a firm employs only two factors or inputs, say, labour (measured in hours) and land (in acres), and, Table 3.1 lists some factor combinations and the corresponding output levels. 1 hour of labour and 2 acres of land produce at the most 5 units output, 2 hours of labour and 4 acres of land produce at the most

Fig. 3.1

Linkages

These linkages are depicted in fig. 3.1. In Section 3.1, we will study the relationship between inputs and

Table 3.1 Production Function Labour (in hours) A B C D E F G H 0 1 2 3 4 5 6 7 Land (in acres) 0 2 4 6 8 10 12 14 Output (in units) 0 5 11 18 24 30 35 40

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

Finally, we define Average Product or Average Physical Product (APP) as the TPP per unit employment of the variable input, i.e., APP = TPP/L, where L is the level of employment of the variable input. These are also respectively called total, marginal and average returns to an input. A numerical example showing a TPP schedule is given in Table 3.2, where the variable input, L, is called labour. If we graph a TPP schedule, we get a total physical product curve. Table 3.2 A Total Physical Product Schedule Labour Hours employed (L) 0 1 2 3 4 5 6 7 8 9 Total Physical Product (TPP) 0 10 22 33 43 51 56 56 48 36

2 3 4

Table 3.1 gives only some, not all, possible combinations of inputs and output. Also, we can differentiate between unskilled labour and skilled labour. These are respectively similar to the concepts of total utility and marginal utility discussed in Chapter 2.

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49

Fig. 3.2 shows the TPP curve for the TPP schedule given in Table 3.2.

Fig. 3.2 The Total Physical Product Curve Corresponding to Table 3.2

the MPP at L = 2, which is 12, is equal to the difference between TPP at L = 2, which is 22, and TPP at L = 1, which is 10. The MPP schedule corresponding to the TPP schedule in Table 3.2 is given in column (2) of Table 3.3. Likewise, the APP schedule, given in column (3) of Table 3.3, is obtained through dividing TPP by L in Table 3.2. The graphs of an MPP schedule and an APP schedule are respectively called the marginal physical product curve and the average physical product curve. These graphs corresponding to Table 3.3 are given respectively in figs. 3.3 and 3.4. Note the following : 1. It is not true that the concepts of TPP, MPP and APP are applicable to

The marginal physical product, MPP, is derived from the total physical product, TPP, just as marginal utility is obtained from total utility. For instance, Table 3.3

Marginal Physical and Average Physical Product Schedules Marginal Physical Product (MPP) 10 12 11 10 8 5 0 -8 -12 Average Physical Product (APP) 10 11 11 10.75 10.20 9.33 8 6 4

Labour Hours employed (L) 0 1 2 3 4 5 6 7 8 9

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one particular input (e.g. labour) and not to others (e.g. land or

Fig. 3.3

The Marginal Physical Product Curve Corresponding to Table 3.3

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

Fig. 3.4

The Average Physical Product Curve Corresponding to Table 3.3

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

PRODUCTION

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51

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

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

Fig. 3.5 Three Stages of Production and Diminishing Returns

maximising firm will not operate in stage I either. That leaves out only stage II, in which the marginal returns to an

52

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

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

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

Fixed and Variable Costs At a given point of time, a firm faces two types of costs: fixed costs and variable costs. Fixed costs are those that do not vary with the level of output. (These are also called overhead

This holds as long as the MPP of each factor is positive, i.e., the firm is not operating in stage III.

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53

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

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

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Table 3.4 Output 0 1 2 3 4 5 6 7 8 9

Total Fixed Costs and Total Variable Costs Total Variable Costs (Rs.) 0 8 13 16 20 26 35 47 63 83 Total Costs (Rs.) 10 18 23 26 30 36 45 57 73 93

Total Fixed Costs (Rs.) 10 10 10 10 10 10 10 10 10 10

ATC curves slope downwards initially and then upwards, i.e, they are U-shaped. The reason behind this shape will be discussed later. Marginal Costs There is another important cost concept, the marginal cost (MC). Similar to marginal utility or marginal product, this is defined as the increase in total cost when one extra unit is produced. Thus, it is the (additional) cost of producing an extra unit. In the example given in Table 3.4, suppose that the current level of output is 7. The MC of this output level is Rs. 12. It is because the 7th unit of output costs Rs. 57 Rs. 45 = Rs. 12. The MC schedule corresponding to Table 3.4 is given in Table 3.6.

Fig. 3.6

TFC, TVC and TC Curves corresponding to Table 3.4

Table 3.4 are given in Table 3.5, and fig. 3.7 graphs them. The AFC curve continuously decreases as output increases, because the numerator of the ratio TFC/Output is constant while the denominator increases. The AVC and

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55

Table 3.5 Output 0 1 2 3 4 5 6 7 8 9

AFC, AVC and ATC Schedules (Based on Table 3.4) AFC (Rs.) AVC (Rs.) ATC (Rs.) 10 5 3.33 2.50 2 1.66 1.43 1.25 1.11 8 6.50 5.33 5 5.20 5.84 6.71 7.875 9.22 18 11.50 8.66 7.50 7.20 7.50 8.14 9.125 10.33

Fig. 3.7 AFC, AVC and ATC Curves Corresponding to Table 3.5

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

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

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As you see from fig. 3.8 or fig. 3.9, the MC curve is initially decreasing in output and then it is increasing, i.e, it is U-shaped. The reason behind the Ushape of the MC curve is the law of diminishing returns. As you recall, this law says that, as other inputs are kept Table 3.6 Output 0 1 2 3 4 5 6 7 8 9
Costs in Rs .
25 20 15 10 5 0 0 1 2 3 4 5 6 7 8

Marginal Costs (based on Table 3.4) Marginal Cost (Rs.) 8 5 3 4 6 9 12 16 20

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

Fig. 3.9

A Smooth Marginal Cost

MC

Output

10

Fig. 3.8 The MC Curve corresponding to Table 3.6

Let us now turn around the statement of the law of diminishing returns and say equivalently that, as more and more output is produced, initially, the rate of increase in the requirement of the variable input will be less and less, and, after a certain point, it will be more and more. This implies that, initially, the rate of increase in the variable cost which is same as the marginal cost will be less and less as output increases, and then, it will be more and more when output

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

Fig. 3.10

AVC, ATC and MC Curves

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

Indeed, the MC curve is a mirror reflection of the MPP curve. This is contained in Richard Manning and Kenneth Henry, The Logic of Markets, The Dunmore Press Limited, New Zealand, 1983, Chapter 7.

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

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

Fig. 3.11 The Long-Run Average and Marginal Cost Curves

The short-run and long-run average or marginal cost curves are not unrelated however. As you will learn in a higher course in microeconomics, the LAC curve is flatter than short-run average variable cost curves.

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

plans to buy 200 tons of yarn it can negotiate a better price. However, as the output level goes beyond a certain limit, difficulties in managing an enterprise crop up. Crowding and congestion occur typically, which lead to decreasing returns to scale. In between IRS and DRS, a firm experiences constant returns to scale. It is shown at point q0 in fig. 3.11. More generally, CRS may prevail over a range of output, rather than at a single level of output. In this case, the LAC will have a flat portion in the middle. A couple of remarks are in order: First, given that initially increasing returns, then constant returns and finally decreasing returns to scale occur as output increases, the long run average cost is minimised where constant returns to scale prevail, such as at point q0. In some sense, this is the level at which production is most efficient. Second, the U-shape of the LAC curve implies the U-shape of the LMC curve. This is different in nature from the short run, where the U-shape of the marginal cost curve implies the U-shape of the average cost curve. The concepts developed in this chapter will be used very much in the following chapters.

The same applies to other kinds of workers and to machinery and land. For instance, at a small scale of operation, the firm may have only one room, which is used as a storage as well as office space for its employees. Storing merchandise and taking them out generate traffic, which would adversely affect the productivity of other employees. If, instead, the firm acquires an additional room, one of them can be used as storage only and as a result the productivity of employees will improve.

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SUMMARY
l l

l l l

l l l l l l l

l l l l

l l

TPP is equal to the sum of MPPs. There are generally three stages of production. In the initial stage, the MPP increases with input employment, then it diminishes but remains positive and finally it becomes negative. A profit-maximising firm will never employ an input at such a level that its MPP is negative. The MPP and APP curves are generally inverse U-shaped. The law of diminishing returns explains why the MPP curve is inverse Ushaped. In turn, the inverse U-shape of the MPP curve implies a similar shape of the APP curve. In the short run, there are fixed costs and variable costs. In the long run, there are only variable costs. The AFC curve is downward sloping. The MC, AVC and ATC curves are generally U-shaped. The sum of MCs equals the TVC. The area under the MC curve is equal to the TVC. The law of diminishing returns explains why the MC curve is U-shaped. In turn, the shape of the MC curve implies the similar shape of the AVC and ATC curves. The MC curve cuts the AVC curve and the ATC curve at their minimum points. The long run marginal cost (LMC) curve and the long run average cost (LAC) curve are generally U-shaped. The LMC curve cuts the LAC curve at the latters minimum point. The U-shape of the LAC curve follows from a firm experiencing increasing returns to scale initially, followed by constant returns to scale and then by decreasing returns to scale. The U-shape of the LAC curve implies the U-shape of the LMC curve. In the long run, the sources of increasing returns to scale lie in the division of labour and volume discounts.

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EXERCISES

Section I
3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10 3.11 3.12 3.13 3.14 What is a production function? List any three inputs used in production. What is meant by total physical product? What is meant by average physical product? What is meant by marginal physical product? How is total physical product derived from the marginal physical product schedule? What will you say about the marginal physical product of a factor when total physical product is falling? What is the general shape of the MPP curve? What is the general shape of the APP curve? What do returns to scale refer to? Give the meaning of increasing returns to scale. Give the meaning of constant returns to scale. Give the meaning of decreasing returns to scale. Classify the following into fixed cost and variable cost. (a) Rent for a shed. (b) Minimum telephone bill. (c) Cost of raw materials. (d) Wages to permanent staff. (e) Interest on capital. (f) Payment for transportation of goods. (g) Telephone charges beyond the minimum. (h) Daily wages. How does total fixed cost change when output changes? How is total variable cost derived from a marginal cost schedule? How can one obtain total variable cost from a marginal cost curve? What is the general shape of the AFC curve? What is the general shape of the MC curve? What is the general shape of the AC curve? What will happen to ATC when MC > ATC? What does division of labour mean? What are volume discounts? Name two factors behind increasing returns to scale in the long run.

3.15 3.16 3.17 3.18 3.19 3.20 3.21 3.22 3.23 3.24

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Section II
3.25 3.26 What is meant by the law of variable proportions? Calculate the APPs and the MPPs of a factor from the following table on its TPP schedule. Level of Factor Employment 0 1 2 3 4 5 6 7 3.27 TPP 0 5 12 20 28 35 40 42

The following table gives the MPP of a factor. It is also known that the TPP at zero level of employment is zero. Determine its TPP and APP schedules. Level of Factor Employment 1 2 3 4 5 6 MPP 20 22 18 16 14 6

3.28

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

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Level of Factor Employment 1 2 3 4 5 3.29

APP 50 48 45 42 39

3.30 3.31 3.32 3.33 3.34 3.35 3.36

6 35 Explain the law of diminishing marginal returns. In other words, why does the marginal product of an input decline with further employment of it? How does the total physical product change with the change in the marginal physical product of an input? What is meant by the law of diminishing returns? Distinguish between fixed and variable costs. With the help of a suitable diagram, explain the relationship between TC, TFC and TVC. Do ATC and AVC curves intersect? Give reasons. Why is the MC curve in the short run U-shaped? A firm is producing 20 units. At this level of output, the ATC and AVC are respectively equal to Rs. 40 and Rs. 37. Find out the total fixed cost of this firm.

Section III
3.37 A firms total cost schedule is given in the following table. Output (in units) 0 1 2 3 4 5 6 7 8 Total Cost In (Rs.) 40 120 170 180 210 260 340 440 550

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(a) (b) 3.38

What is the total fixed cost of this firm? Derive the AFC, AVC, ATC and MC schedules. Complete the following table if the AFC at 1 unit of production is Rs. 60. Output 1 2 3 4 5 6 7 8 TC 90 105 115 120 135 160 200 260 TVC TFC AVC AFC ATC MC

3.39

A firms fixed cost is Rs. 2,000. Compute the TVC, AVC, TC and ATC from the following table.

Output (in units) 1 2 3 4 5 6 7

Marginal Cost (in Rs.) 2,000 1,500 1,200 1,500 2,000 2,700 3,500

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3.40

Suppose that a firms total fixed cost is Rs. 100, and the marginal cost schedule of a firm is the following. Output (in units) 1 2 3 4 5 6 7 Marginal Cost (in Rs.) 10 20 30 40 50 60 70

(a) (b) 3.41 3.42

Is the MC curve U-shaped? Derive the AVC schedule. Will the AVC curve be U-shaped? Discuss why or why not. Explain the relationship between ATC, AVC and MC with a suitable illustration. Tables A and B below outline two production technologies or production functions. There are two factors: unskilled labour and skilled labour. Show that the production function given in Table A satisfies increasing returns to scale and that in Table B satisfies decreasing returns to scale. Table A Unskilled Labour (in hours) 8 10 12 14 Skilled Labour (in hours) 4 5 6 7 Output (in units) 2 3 4 5

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Table B Unskilled Labour (in hours) 8 10 12 14 3.43 Skilled Labour (in hours) 4 5 6 7 Output (in units) 6 7 8 9

Increasing and decreasing returns to scale respectively imply downward and upward sloping portion of the long run average cost curve. Defend or refute.

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CHAPTER

REVENUES, PRODUCERS EQUILIBRIUM AND THE SUPPLY CURVE


Besides the demand forces, the supply forces constitute the other crucial component of market mechanism. It is the producers who supply goods and services to the market. In the last chapter we studied concepts associated with production and cost, which are relevant for producers. But we did not learn about their choice behaviour i.e. which level of output they should produce so as to maximise their profits. In this chapter we develop the revenue concepts, and, together with the cost concepts, we study profit maximisation. This, in turn, forms the basis of what is called the supply curve. Comparable to the demand curve, the supply curve shows different quantities produced and sold at different prices. In the last chapter, we saw that profits are equal to the difference between total revenues and total costs. We also discussed how total costs change with output. In this chapter, we first analyse how total revenues, defined as price output, change with output. This sets the stage for analysing profit maximisation or what is called producers equilibrium. It is an equilibrium notion in the sense that if the firm selects the level of output at which profit is maximised, it would like to stay or rest at that level of output; there is

4.1 Total Revenues 4.2 Producer's Equilibrium: The Basis of the Supply Curve 4.3 Change in Quantity Supplied Versus Change in Supply 4.4 Determinants of Supply Curves Market Supply Curve

4.5

4.6 Time Horizon 4.7 Price Elasticity of Supply

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

cut or a leather football can be thought of as examples of industries, which are very close to perfectly competitive markets. Because, there are typically many producers of these items. Each of these is a standardised item, i.e., naturally homogeneous. Moreover, it is relatively easy to enter or get out of these businesses.1 The implication of the product being homogeneous or identical is that all firms have to charge the same price for the product. That is because if one producer happens to charge a price higher than some other, no one will buy from the former. Why would anyone pay more for exactly the same item? Hence, all producers who operate in the market must charge the same price. Product homogeneity and the existence of a large number of firms together imply that each firm is very small compared to the whole market and no single firm can influence the market price. That is, each firm is a price taker in perfect competition.2 An example may help to better understand the price taking behaviour. Think of a product like jalebi (a sweet). If you operate a halwai (sweetmeat) shop in a big town in which there are many such halwai shops,

You can of course argue that there may be some differences between wheat produced in Punjab and wheat produced in Australia. But, for most practical purposes, the differences are negligible. Similarly, a standard haircut may differ slightly from one barber to another. But, again, it is essentially the same everywhere. The chosen examples are different from, say, the market for TVs, which are differentiated. There are black and white TVs as well as colour TVs. Even in the category of colour TVs, there are 19" TVs and 29" TVs. TVs differ not just in quality but also in style and design. This does not mean that the market price itself cannot change. How it may change will be studied in Chapter 5.

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and, the market price of jalebi per kg is Rs. 70, you will charge Rs. 70 too. Obviously, you will not charge more than Rs. 70 (and lose a lot of, possibly, all customers). There is also no reason for you to sell at any price less, because being small compared to the market, you can sell as many jalebi as you like at the going price in the market. Thus you will be a price taker. 4.1.2 Total Revenue Curve and Price Line Once you understand that each firm is a price taker and can sell as many units as it wishes at the market price, it is quite simple to relate total revenue (TR) to output.3 For example, if you sell five kilograms of jalebi, the TR is Rs. 70 5 = Rs. 350. If you sell six, it is Table 4.1 Total Revenue Schedule Output In Kg. 0 1 2 3 4 5 6 7 8 TR (Rs.) 0 70 140 210 280 350 420 490 560

Rs. 420 and so on. Table 4.1 reports the total revenue schedule for this example. 4.1.3 Total Revenue Curve and Price Line If we graph the total revenue schedule, measuring output along the x-axis and total revenue along the y-axis, we obtain the total revenue curve. This is depicted in fig. 4.1(a). At zero output, TR is obviously zero. Hence the TR curve must pass through the origin. Moreover, it is a straight line. This is because the market price is independent of how much quantity is sold by one firm. Turn to fig. 4.1(b) now. The y-axis measures price, not total revenues. Since the market price is given or exogenous to the firm, we obtain a horizontal line. This is called the price line. It is also called the demand curve facing a competitive firm in the sense that, from a firms perspective, it is able to sell to the consumers any amount it wishes at the same price. (The price elasticity of this demand curve is infinite.) There is a relationship between the price line and the total revenue. That is, the total revenue is equal to the area under the price line. This is seen in fig. 4.2, in which AB is a hypothetical price line. Suppose that the firm is producing the amount q0. Then, TR = price quantity = OA Oq0 = OADqo, which is the area under the price line.

*Market price jalebi = Rs. 70/kg

The feature (C) of perfect competition, namely, free entry and exit, does not have any direct bearing on how TR changes with respect to output. Its implication will be studied in Chapter 6.

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(a)

(b) Fig. 4.1 Total Revenue Curve and the Price Line corresponding to Table 4.1

4.1.4 Average Revenue and Marginal Revenue These are two more revenue concepts. Average Revenue (AR) is defined as revenue per unit of output. It is equal to TR/output. Note that, since TR = price output, AR is always equal to price. Marginal revenue is defined as the increase in total revenue when one extra unit is sold, i.e., it is the revenue obtained from one extra or last unit sold.4 Since a competitive firm is a price taker, if it sells one extra unit, the extra r evenue generated will be equal to whatever the price is. Thus, for a competitive firm, MR = price.5 However, the terms of AR and MR will not be used much in this chapter. But they will be in Chapter 6. Here they are introduced for the sake of completeness. 4.2 PRODUCERS EQUILIBRIUM: THE BASIS OF THE SUPPLY CURVE We are now ready to study producers equilibrium. The question is at what level of output will a firms profit be maximised? Unlike the numerical method that was used in Chapter 2 to study consumers equilibrium, we use a graphical method to answer this question. In order to do so, we need two results from our study of costs and revenues:

Fig. 4.2

Price Line and Total Revenues

4 5

This is similar to the concept of marginal utility or marginal cost. This is not true for a firm, which is not perfectly competitive.

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

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

Fig. 4.3 Profit Maximisation

4.2.2 Rationale Behind the Condition, P = MC In Chapter 2 we saw that diminishing marginal utility is the key behind the consumers equilibrium condition of marginal utility is equal to price. In a parallel way, the key reason behind the producers equilibrium condition, P = MC, is that marginal cost be increasing with output. To see this, suppose that, starting from the level of output at which P =MC,

Observe the similarity of this condition with the condition for consumers equilibrium in Chapter 2, which stated that marginal utility be equal to price.

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the firm decides to produce one unit more. Given that MC is increasing in output, P will be now less than MC. But P and MC are respectively equal to extra revenues earned and extra costs incurred. Hence, extra revenues will be less than the extra costs, implying that the profits will be less. Similarly, suppose that the firm decides to produce one unit less than where P = MC. In this case the revenues sacrificed (equal to P) are greater than savings in costs (equal to MC). Hence, profits will also be less. In summary then, increasing or decreasing output from where P = MC results in less profits. Thus, profit is maximised where P = MC, as long as MC is increasing in output. The above discussion implies that, if at any given market price there is a level of output at which P = MC holds

but MC is decreasing, it cannot be the profit-maximising level of output. Such a possibility is shown in fig. 4.4. At price P1, the price line cuts the MC a b curve at two points, q1 and q1 , but, b a unlike at q 1 , at q 1 , MC decreases. Therefore, the profit-maximising b a output is q1 not q1 .7 The preceding analysis gives rise to an important conclusion: a competitive firm chooses an output only on the rising portion of the MC curve. 4.2.3 A More General ProfitMaximising Condition

Recall the definition of MR, the marginal revenue, and that P = MR for a competitive firm. Thus we can write (A) as MR = MC. That is, marginal revenue is equal to marginal cost. Indeed, this is a very general condition of profit-maximisation something that holds irrespective of the market structure. Having noted this, we however return to P = MC as our profit-maximising condition for a competitive firm. 4.2.4 Law of Supply and the Supply Curve The law of supply states that, other things remaining unchanged, an increase in the price of a product leads to an increase in the quantity supplied of it. It is because, higher the price, the more a producer wants to supply.

Fig. 4.4

Profit Maximising Outputs at Different Prices

a Suppose the firm is producing at q1 . If it increases output by one unit, the extra revenue generated is P1 and the extra cost incurred is equal to MC. But since MC is decreasing, P1 > MC, and thus profit is a higher. You can similarly argue that profit is less also if output is reduced by one unit from q1 . Hence, a profit is not maximised at q1 .

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Other things refer to other determinants of supply, which will be discussed later. This law, stated in a tabular form, gives rise to the supply schedule, and, the graph of a supply schedule gives the supply curve. Table 4.2 lists a supply schedule. Figure 4.5 graphs the corresponding supply curve. What is the basis of the law of supply or the supply curve? Refer back to fig. 4.4. We see that, at price P1, the b firm produces the amount q1 , at price P2, it produces q2; and so on. Hence all Table 4.2 A Supply Schedule Price (Rs.) 5 10 15 20 25 Quantity Supplied 0 7 16 28 43

price-output combinations are simply the points on the rising part of the MC curve. We can think of the output as the amount supplied to the market (assuming implicitly that the firm does not store anything beyond one period). Hence it follows that the rising portion of the MC curve is the supply curve itself ! 8 4.3 CHANGE IN QUANTITY SUPPLIED VERSUS CHANGE IN SUPPLY

The difference between these two terms is similar to the difference between a change in quantity demanded and a change in demand. A change in quantity supplied refers to a movement along a given supply curve because of a price change, whereas a change in supply means a shift of the supply curve due to a change in other factors. It is now the time to discuss these factors. 4.4 DETERMINANTS SUPPLY CURVE OF THE

Fig. 4.5 The Supply Curve for the Supply Schedule in Table 4.2

Since the supply curve is a part of the marginal cost curve, the factors that shift the marginal cost curve are the determinants of supply or the supply curve. Generally, there are two such factors, technological changes and changes in factor or input prices. Besides, in India particularly, on many industrial goods, there are taxes that are based on the total production

Strictly speaking, the supply curve is only a portion of the rising part of the MC curve. The reason for this will be covered in a higher course in micro economics.

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

printed pages are much less today than they were prior to 1980s. This is an example of cost-saving technological change. In the real world, there are many such examples.11 Such a technological advance lowers marginal cost at any given level of output. Table 4.3 illustrates this. Column (2) lists an old marginal cost schedule. Column (3) lists the new one after the technological change.12 Notice that each entry in Column (3) is smaller than the corresponding entry in Column (2), meaning that the marginal cost has decreased for any given level of output. The two marginal cost schedules are plotted in fig. 4.6. As we can see, the new MC curve lies below or to the right of the old one. Since the MC curve is essentially the supply curve, we have the result that a technological progress shifts the supply curve to the right. 4.4.2 Input Price Changes Changes in raw material prices, wages to workers etc. can also affect the marginal cost curve and the supply curve. Suppose you own a haircut

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

10

11 12

There are chance factors like weather changes or health of workers, which can also shift the marginal cost curve. But we ignore them here. The supply curve is also influenced sometimes by price speculations. In times of disasters like earthquake, war, famine and cyclones, prices of essential goods typically rise. Some private producers take advantage of this situation by hoarding, that is, withholding supply of their product to the market, expecting to sell later at very high prices. We ignore these factors in this chapter. Once manuscripts of books were prepared by authors in long hand, the alphabets in the manuscripts used to be set in a frame and the frame would be mounted on a letter-press machine. The pictures and diagrams were etched on metal plates. The whole plate had to be changed if changes were to be made in the pictures or diagrams. The metal plate and the frame were mechanically inked and pressed on to paper to produce a page of the book. There is another kind of technological progress that we do not consider here, namely, development of new products. For simplicity, in both cases, the marginal cost always increases with output.

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Table 4.3 A Decrease in Marginal Costs due to Technological Change Output 0 1 2 3 4 5 Old MC (Rs.) 7 8 12 14 17 22 New MC (Rs.) 3 4 7 9 13 17

of an increase in input prices is shown in fig. 4.7.

Fig. 4.7 Increase in Input Prices and the Shift of the Supply Curve

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

Fig. 4.6 Technological Progress and Shift of the Supply Curve

saloon, employ 10 barbers and service 120 haircut jobs a day now. The hourly market wage of barbers increases for some reason. This will increase the cost of the haircut service that you provide and shift your marginal cost curve up or to the left. As a result, you will employ fewer barbers and service less number of haircuts. In general then, an increase (a decrease) in an input price shifts the supply curve to the left (right). The case

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

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

Fig. 4.8

Individual Supply Curves and the Market Supply Curve

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

is called the market period in economics. By definition, it is that short a period within which firms cannot adjust their output to any change in price. As a result, the supply curve of a firm or the whole industry is vertical. In a longer run i.e. in the short run or long run the supply curve will be upward sloping, as drawn earlier, because inputs can be changed.

Fig. 4.9 Supply Curve in the Market Period

4.7 PRICE ELASTICITY OF SUPPLY 4.7.1 Definition and the Percentage Method of Measurement Parallel to price elasticity of demand, the price elasticity of supply quantifies the responsiveness of quantity supplied to changes in price. It is defined as (B) Price elasticity of supply = es

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

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% change in the quantity supplied % change in the price


On a given supply curve, let P0 and S 0 denote the original price and quantity. If the price rises to P1 and quantity supplied increases to S1, the % changes in price and quantity supplied are respectively [(P1 P0 )/P0] 100 and [(S1 S0 )/S0] 100. Hence

S0 = 5,000, P1 = Rs. 10 and S1 = 8,000. Thus,


[(P 1 P ) / P ] 100 0 0 [(10 8) / 8] 100 25,

and

[(S1 S 0 ) / S 0 ] 100 = [(8000 5000)]/ 5000] 100 = 60.


Hence, eS 60 / 25 2.4. Just as in case of price elasticity of demand, (a) the price elasticity of supply is independent of units, and (b), if two supply curves intersect, the flatter one has higher price elasticity at the point of intersection. The reasons are exactly parallel what they were in case of price elasticity of demand. 4.7.2 The Geometric Method Also similar to point elasticity of demand, for very small price changes, the price elasticity of supply can be measured by a convenient geometric formula. Refer to fig. 4.10. It shows three straight line supply curves. Panel (a) illustrates one, in which the supply curve, extended towards the x-axis, intersects the x-axis in its negative

(S S 0 ) / S 0 S / S 0 = (C ) es = 1 , (P1 P0 ) / P0 P / P0
where denotes the change. If the supply curve is vertical, then the price elasticity of supply is, obviously, zero. Otherwise, given that the supply curve is positively sloped, the price elasticity is positive. As a numerical example, suppose that you manufacture one type of ballpoint pens. When they were selling at the price Rs. 8, you produced and sold 5,000 pens a month. Now its market price has increased to Rs. 10 and you are producing and selling 8,000 pens a month. In this example, P0 = Rs. 8,

(a) Fig. 4.10

(b)

(c)

Price Elasticity associated with Straight Line Supply Curves

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

Thus, along the supply curve in panel (a), the price elasticity is greater than one (as BC > 0C). By the same argument, along the supply curve in panel (b), it is less than one (as BC < 0C). Finally, in panel (C), you can say that the point B is same as the origin. Thus BC = 0C implying e s=1. That is, any straight line supply curve passing through the origin, irrespective of how steep or flat it is, implies price elasticity of supply equal to one.

CLIP 4-1
Does computerisation reduce employment? This is a sensitive issue for a populous country like India. The traditional thinking is that computerisation or for that matter, any technical improvement that is labour-saving is or must be bad for employment. If you replace a person with a machine, how could it not reduce employment? This is, however, a narrow point of view, having two major flaws. First, it has a very short run perspective, and second, it presumes that those who are replaced by computers or machines do not have or are incapable of developing any other skills and hence must remain unemployed for a long time. Yes, at the time when a machine is replacing a person or many persons, it has a negative effect on employment. But this is hardly the end of the story. A firm is doing it in order to save costs. As the total variable cost curve shifts down, so does the marginal cost curve. This means that the supply curve will shift out and more will be produced in the new equilibrium. From the whole economys perspective, the production possibility curve (see Chapter 1) shifts out. Higher output would require more employment of workers, both skilled and unskilled. Also, computerisation by itself creates demand for new types of jobs. Hence there is little reason to believe that computerisation will reduce employment in the long run. On the other hand, it leads to a greater productivity of workers and higher wages. The negative effects of computerisation are present only in the short run. A traditional typist who is replaced by a computer can learn word processing and possibly land a more paying job. Of course, computerisation or mechanisation may, for example, take away the job of artisans, who with their own bare hands, make beautiful handicrafts. On the other hand, expansion of the small-scale
14

The proof of this is beyond our scope.

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industries due to computerisation will lead to more employment. In the worst case, one type of job is replaced by other type of job: the workers who lose their jobs and cannot change their skills may not get their jobs back, but other category of workers will now find jobs. In summary, there may be employment costs of computerisation, but only in the short run. On the other hand, there are major long-run benefits.

SUMMARY
l l l l l l l l l l l l l

The total revenue curve facing a competitive firm is a straight line passing through the origin. The price line facing a competitive firm is horizontal because this firm is a price taker. The price line is also interpreted as the demand curve facing a competitive firm. A perfectly competitive firm maximises profits, i.e., attains producers equilibrium, when price is equal to the marginal cost. In general, a firms profit maximising condition is that marginal revenue is equal to marginal cost. The profit-maximising condition, price is equal to marginal cost, forms the basis of the supply curve. Increasing marginal cost explains the law of supply or why the supply curve is upward sloping. A firms supply curve consists of the rising portion of its marginal cost curve. A cost saving technological progress shifts the marginal cost curve down and hence shifts the supply curve to the right. An increase in input prices shifts the marginal cost curve up and hence shifts the supply curve to the left. An increase in the rate of the excise duty shifts the supply curve to the left. An increase in the price of a substitute good in production shifts the supply curve of the product in question to the left. Market supply curve is obtained by horizontally summing up the individual supply curves.

REVENUES, PRODUCER'S EQUILIBRIUM


l l l l l l

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SUPPLY CURVE

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An increase in the number of firms shifts the market supply curve to the right. During the market period, the individual and the industry supply curves are vertical. Price elasticity of supply measures the responsiveness of quantity supplied to a change in its own price. A straight line supply curve which intersects the x-axis in its negative range implies price elasticity of supply greater than one. A straight line supply curve which intersects the x-axis in its positive range implies price elasticity of supply less than one. A straight line supply curve passing through the origin implies price elasticity equal to one, irrespective how steep or flat it is.

EXERCISES

Section I
4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 4.10 What is meant by producers equilibrium? What is the relationship between total revenue, price and quantity sold? What is the relationship between price and marginal revenue for a competitive firm? What is the condition of producers equilibrium for a competitive firm? What is the condition of profit maximisation for a competitive firm? What is the general profit maximising condition of a firm? What is meant by the Law of Supply? What is meant by a change in the quantity supplied? What is meant by a change in supply? Due to improvement of technology, the marginal costs of production of televisions have gone down. How will it affect the supply curve of television? What effect does a cost saving technical progress have on the supply curve? What effect does an increase in input price have on the supply curve? What effect does an increase in excise tax rate have on the supply curve of the product?

4.11 4.12 4.13

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4.14 4.15 4.16 4.17 4.18 4.19

If a farmer grows rice and wheat, how will an increase in the price of wheat affect the supply curve of rice? What is meant by market period? How will an increase in the number of firms shift the market supply curve? What does price elasticity of supply measure or quantify? If two supply curves intersect, which one does have higher price elasticity? What is the price elasticity associated with a straight line supply curve passing through the origin?

Section II
4.20 4.21 4.22 4.23 Why is the total revenue curve facing a competitive firm a straight line passing through the origin? What factors determine the market structure? What are the features of perfect competition? What is meant by a product being perfectly homogeneous? What is its implication for the price charged by producers in the market? Briefly explain why a perfectly competitive firm is price-taker in the market. A perfectly competitive firm faces market price equal to Rs. 15. (a) Derive its total revenue schedule for the range of output from 0 to 10 units. (b) Suppose the market price increases to Rs. 17. Will the new TR curve be flatter or steeper? Complete the following table when each unit of a commodity can be sold at Rs. 5. Quantity Sold 1 2 3 4 5 6 7 TR MR AR

4.24 4.25

4.26

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4.27

A firms TR schedule is given in the following table. What is the product price facing the firm? Output 1 2 3 4 5 TR (Rs.) 7 14 21 28 35

4.28 4.29 4.30 4.31 4.32 4.33 4.34

4.35

4.36

Why is AR always equal to MR for a competitive firm? Name three factors that can shift a supply curve. Give two examples where technological progress leads to a shift in the supply curve. How does a change in the price of inputs affect the supply curve of a commodity and why? How does an increase in the rate of excise tax shift the supply curve and why? How does a cost saving technological progress shift the supply curve and why? A new technique of production reduces the marginal cost of producing stainless steel. How will this affect the supply curve of stainless steel utensils? Because of cyclone in a coastal area, the sea level, covers a lot of rice fields. This reduces the productivity of land. How will it affect the supply curve of rice of that region? Consider the following individual and market supply schedules. Price (in Rs./kg.) 1 2 3 4 5 Firm A (kg.) 37 40 44 48 Firm B (kg.) 20 30 50 60 Firm C (kg.) 45 50 55 65 Market (kg.) 100 135 154

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(a)

4.37

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

4.38

The above diagram shows the supply curve of 3 commodities. Rank their price elasticities.

Section III
4.39 Show that the rising portion of the marginal cost curve is the supply curve of a competitive firm.

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U N I T- I V
FORMS
OF

MARKET

AND

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DETERMINATION

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CHAPTER

PRICE DETERMINATION UNDER PERFECT COMPETITION


5.1 Market Equilibrium and Determination of Price and Quantity 5.2 Demand and Supply Shifts 5.3 Sources of Demand Shifts 5.4 Sources of Supply Shifts 5.5 Anatomy of Famines 5.6 Efficiency of the Price Mechanism and Competitive Markets 5.7 Economic Policy by the Government and Market Equilibrium

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

Consider fig. 5.1. It depicts the market demand and supply curves of a particular product, denoted respectively by DD and SS. The question is: which price will prevail in the market? Suppose that, initially, the price

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87

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

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

Fig. 5.1 Market Equilibrium

As a numerical example, consider Table 5.1, which gives the demand and supply schedules of bananas (in a given geographical location and within a given time period). The equilibrium price is Rs. 21, since at this price quantity demanded matches with quantity supplied. The equilibrium quantity sold/purchased is 6,000 dozens. The corresponding demand and supply curves and market equilibrium are shown in fig. 5.2.

The term excess demand here refers to a particular commodity or service. This is different from what is meant by excess demand in macroeconomics.

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Table 5.1

An Example of Demand, Supply and Equilibrium Quantity Demanded (in dozen) 10,000 8,000 7,000 6,000 5,000 4,500 Quantity Supplied (in dozen) 1,000 2,000 4,000 6,000 7,500 8,500

Price of Bananas per dozen (in Rs.) 18 19 20 21 22 23

Fig. 5.2 Market Equilibrium Corresponding to Table 5.1

which any positive amount can be supplied is higher than what the consumers are willing to pay. Put differently, costs are too high for any positive output to be produced. In India and many other countries, commercial aircraft is such an example, i.e., it is not produced at all. Of course, an industry, which is not viable in one country, can be viable in some other. For example, commercial aircrafts are produced in America, Russia, Britain and France.2

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

Fig. 5.3

A Non-Viable Industry

Computer memory chips, mother boards and copying machines are other examples. These are totally imported, not produced at all in India.

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

(b) Fig. 5.4 Demand Shifts

Turn to fig. 5.4(a). Let the initial demand and supply curves be DD0 and

SS0 respectively. Accordingly, the initial price and quantity are respectively P0 and Q0. Now let the demand curve shift to the right, as shown by DD1. We see immediately that the equilibrium point shifts from E0 to E1. The new price and quantities are P1 and Q1 respectively. Thus both price and quantity increase. It is important to understand the economic process that leads to these changes. Starting from the initial situation of no excess demand or supply [at E0 in fig. 5.4(a)], a rightward shift of the demand curve moves the consumption point from E0 along DD0 to A along DD1.

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

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

(a)

Fig. 5.5

(b) Supply Shifts

5.2.3

Supply Shifts

Now consider supply shifts, shown in fig. 5.5. In panel (a) the original demand

It is possible that both demand and supply shifts occur simultaneously. Their net impact on price and quantity will be a combination of 1 and 2 in Table 5.2. For example, the demand and supply curves both shift to the right. Then the market price may increase or decrease, but the quantity exchanged will increase unambiguously. The opposite happens if both curves shift to the left. Similarly, if the demand curve shifts to the right and the supply curve to the left, the market price will unambiguously increase, while the

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91

Table 5.2

Summary of Demand and Supply Shift Effects

1. A rightward (leftward) shift of the demand curve leads to an increase (a decrease) in market price and an increase (a decrease) in the quantity exchanged. 2. A rightward (leftward) shift of the supply curve leads to a decrease (an increase) in market price and an increase (a decrease) in the quantity exchanged. quantity exchanged may increase or decrease. The opposite happens if the demand curve shifts to the left and the supply curve to the right. We return now to demand and supply shifts one at a time, examine their causes, and, by using Table 5.2, their effects of price and quantity. 5.3 SOURCES OF DEMAND SHIFTS Recall from Chapter 2 that the market demand curve can shift because of changes in income, prices of related goods, tastes or size of the market. We analyse each of these in turn. 5.3.1 A Change in Income If it is an inferior good, we know that an increase in income shifts the demand curve to the left. Fig. 5.4(b) then applies: both price and quantity fall.
Example 5.1 Market for Real Estate in Kerala.

Suppose that there is an increase in aggregate income in an economy. We know from Chapter 2 that, as long as a product is normal, the demand curve for it shifts to the right. Fig. 5.4(a) applies. Both price and quantity increase. For a decrease in income fig. 5.4(b) applies. Both market price and quantity fall. Therefore, for a normal good, an increase (a decrease) in income leads to increases (decreases) in the price and quantity exchanged.
3

Think of the market for land, flats etc. The 1990s saw a large increase in urban land price and a vast increase in the number of single-houses and apartment buildings in Kerala, especially in towns like Cochin, T richur, Kottayam, Chalakudi and Chavakkad. It was not because there was a massive industrialisation or an unusual population explosion in these areas. Instead, the reason was that a lot of Keralites from these areas moved to the Middle East countries to work and earned substantial income there.3 They used that income to buy more and better housing at home. This shifted out the market demand curve for housing in urban Kerala. In some places the land price almost trippled in two years.4 Example 5.2 Japan in late 1980s and early 1990s. In this period, as the Japanese economy was growing strongly, various name

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

92
brand products became the outlet for rising income. For example, there was an increase in demand for Levis jeans and Nike shoes. As a result, the prices and quantities sold of these items in Japan soared.5

INTRODUCTORY MICROECONOMICS

as its quantity will fall. Hence, as the price of a complementary good increases, the price of a given product and its quantity exchanged both decrease.
Example 5.3 Prices of Coffee and Tea in the World Market in the Late 1990s. Brazil is a major producer in the world coffee market. In 1994, it was hit by two severe frosts, which damaged more than half of its coffee trees. As a result, the price of Brazilian coffee in the world market shot up and it remained high in the next few years. With a lag of two years, the price of tea in the world market also jumped up (while the production of tea was still growing). This can be interpreted as a delayed effect of an increase in the price of coffee on demand for tea.6

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

5.3.3 A Change in Tastes Think about the market for bitter gourd.7 Surely it is not a very popular vegetable in your age group. But imagine that medical research shows that eating 100 grams of bitter gourd per day prevents pimples on the face. This will definitely generate a

See William Baumol and Alan Blinder, Economics: Principles and Policy, 8th Edition, Harcourt College Publishers, 2000, page 80. Also see JETRO (Japan External Trade Organization), The Japanese Consumer: From Boom to Reality, 1994, http://www.jetro.go.jp/it/e/pub. In the New York wholesale market, Brazilian coffee sold for $1.43/pound in 1994, compared to 66.58 cents in 1993, i.e. it more than doubled. It remained high for the next four years ($1.46, $1.20, $1.67 and $1.22 in 1995, 1996, 1997 and 1998 respectively). During the same time period, the wholesale tea prices, as quoted in the London auction market, were 84.20 cents, 83.15 cents, 74.46 cents, 80.36 cents, $1.08 and $1.08 per pound for the years 1993, 1994, 1995, 1996, 1997 and 1998. Observe that the tea price went up particularly in 1997 and 1998. However, the world production of tea in 1997 was 2% higher than that in 1996, and, in 1998, it was 11% higher than it was in 1997. The Data sources are the following. For coffee and tea prices, it is International Monetary Fund, International Financial Statistics Yearbook 2000. For tea production, it is the web site of UK Tea Council, namely, http://www.teacouncil.co.uk. This is called karela in Hindi, kalara in Oriya and Pavakkai in Tamil.

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Example 5.4 Market for Air Travel.

Consider air travel. After the terrorist attacks in America on September 11, 2001, many people became afraid of flying. This can be thought of as an adverse change in tastes due to fear of flying, which would shift the demand curve for air travel to the left. The price of air tickets would fall and less number of people would travel. These things did happen. Shortly after that day, there was a major decline in the ticket price of air travel within America and a large decrease in the number of passengers. Many airlines had to reduce their scales of operation drastically.

Example 5.6 House Price Rise in Vancouver, Canada, during 1990-1995.

5.3.4 A Change in Market Size By now you should know immediately how this affects price and quantity. An increase in population would shift the market demand curve to the right and result in a higher price and a higher
8 9 10

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

Recall that a change in taste does not only include a change in taste in ones mouth; it means a change in demand due to reasons other than price or income changes. Overall, migration from overseas contributed 79% to the net population growth of Vancouver. The source of this material is David Ley and Judith Tutchener, Immigration and Metropolitan House Prices in Canada, Research on Immigration and Integration in the Metropolis Working Paper Series, Vancouver Centre of Excellence, March 1999.

change in your food habits.8 Many of you will start to eat more bitter gourd than before. The market demand curve will shift out. We can use fig. 5.4(a), and deduce that price of bitter gourd as well as the total quantity produced and consumed of it will increase. Likewise, a decline in liking for a product will cause opposite changes. Thus, a favourable (an unfavourable) change in taste will cause product price and quantity exchanged to increase (decrease).

quantity, whereas a decrease in the population will do the opposite.


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

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5.4 SOURCES OF SUPPLY SHIFTS In Chapter 4 we learnt that technological progress, changes in input prices, changes in excise taxes or changes in the prices of related goods in production cause shifts in a firms supply curve and hence shifts in the market supply curve. Moreover, a change in the number of firms shifts the market supply curve without affecting the individual supply curves. 5.4.1 Technological Progress It shifts the supply curve to the right. Fig. 5.5(a) applies. Thus, technological progress leads to a fall in price and an increase in quantity exchanged.
Example 5.7 Micro-computer CPUs.

5.4.2 Change in Input Prices From Chapter 4 we know that the supply curve shifts to the right or left, as an input price decreases or increases. Therefore, in view of figs. 5.5(a) and (b), the product price decreases and the quantity rises or the price increases and the quantity falls according as an input price decreases or increases.
Example 5.8 Personal Computers.

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

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

Note carefully that Example 5.7 was about a decrease in input price due to technological progress, whereas in Example 5.8 the product price decreases because of decrease in input prices.
Example 5.9 Internet Caf Rates in India.

These cafes have sprawled in many cities, big and small, all over India. In the year 2000, in Delhi an hourly

11

For example, at the time of writing this book, my desk-top computer had a 550 MHz CPU in it.

PRICE DETERMINATION UNDER PERFECT COMPETITION


rate for internet surfing was no less than Rs. 50. In 2002, it came down to an average Rs. 15 in many such cafes. 12 This is because of reduction in input prices. First, the price of computers came down. Second, the internet access charges to these cafes by ISPs (Internet Service Providers) such as VSNL (Videsh Sanchar Nigam Limited), Satyam etc. went down. Third, in connecting to the ISPs, instead of phone lines, cable lines could be used, which are cheaper and through which the connection can be kept uninterrupted for 24 hours a day.

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5.4.4 Increase in the Price of Substitute Goods in Production It was also discussed in Chapter 4 that an increase in the price of a substitute good in production shifts the supply curve of a given product to the left. Applying fig. 5.5 we can then say that an increase (a decrease) in the price of a substitute good in production leads to an increase (a decrease) in price and a decrease (an increase) in quantity. 5.4.5 Number of Firms Even when the individual supply curve does not shift, the market supply curve can if the number of suppliers in the market changes. We already know that an increase in the number of firms (which can be interpreted as greater competition) shifts the market supply curve to the right. A decrease in the number of firms, i.e., less competition does the opposite. Thus, from figs. 5.5(a) and (b), price falls and quantity rises or price rises and quantity falls, as there is more or less competition in terms of the number of firms.
Example 5.11 Mobile Phone Rates.

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

In the union budget of 2002-2003, the special excise duty on cosmetics and toiletories, 16% earlier, was completely removed. As soon as it happened, major companies like Hindustan Livers Ltd. (HLL), Godrej and Proctor and Gamble (P & G) reduced prices in this category of products. For example, HLL reduced prices across a variety of brands including Clinic and Sunsilk shampoos, Ponds skin creams, Ponds talc and Lakme make-up products.

12

This rates were found from the authors own survey.

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

96
were four companies : Bharati's AirTel, Hutchison's Hutch (which acquired Essar), MTNL's Dolphin and Tata-Birla -AT & T's Idea. The mobile phone rates have come down drastically. Incoming calls in some schemes are even free.

INTRODUCTORY MICROECONOMICS

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

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

13

In the Bengal Famine of 1943 for example, one of the worst famines of the 20th century, an estimated 16 lakh people died.

In October -November of 1998, the onion price in India increased 6 to 10 times from its usual price. Onion being a very common vegetable, consumed by most households, it became a very politically sensitive issue. The reason behind this unprecedented onion price rise was heavy rains and flooding in the onion growing areas in India, which caused a drastic decrease in supply of onions to the market in that year.

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does not get the minimum amount for survival and there is a large-scale starvation. Professor Amartya Sen of India, the only Nobel laureate in economics in Asia thus far, calls this the FAD theory, with FAD standing for food availability decline. In what follows, the FAD theory is illustrated in terms of the demandsupply analysis. Professor Sens own theory of famines is different. For those who are interested, Appendix 3 illustrates his theory in terms of the demand-supply analysis.14 See Clip 5-1 for a short bio-sketch of Amartya Sen. 15 5.5.1 The FAD Theory Let the staple food be called rice. Turn to fig. 5.6, which depicts the individual and market demand curves for rice as well as the market supply curve of rice. Let us say that there are three families, A, B and C, in the market. The panels (a), (b) and (c) graph their demand curves respectively. The B-type familys demand curve lies to right of that of the A-type and the C-type familys demand curve lies to right of that of the B-type. We can interpret the A-type as the poorest, the B-type as the next poorest and the C-type, the richest.
14

Note that when the price of rice is p1, the A-type family cannot afford to buy any rice at all, but the B-type or the C-type family can. As shown, this price is above the point at which the DDA, curve intersects the price axis. Hence, the A-type familys quantity demanded is zero. This is not true for the B-type or the C-type family. The former demands the amount B1, and the latter the amount C1. If the market price is p2 the A- and B-type families cannot buy rice but the C-type can; its quantity 16 demanded is C2. Panel (d) depicts the market demand curve, DD M as the horizontal summation of the three individual demand curves. This graph assumes that there is one family of each type. But it is not a major assumption at all. If there are two or more families of any given type, the market demand curve is obtained by horizontally summing the demand curves of all families. The resulting curve will look similar to DDM. From the supply side, let the total available amount initially be M0. It is drawn vertical to represent that, after the harvest, this is the total, potential amount available for consumption.17 The equilibrium price is then p0. At this price, all families are able to buy rice. The types A, B and C respectively buy

15 16 17

The material on FAD theory and Sens own theory is based on Sen, A.K., Poverty and Famines: An Essay on Entitlement and Deprivation, Oxford University Press, 1981. The demand-supply version of these theories is the authors own copyrighted work, based on Theories of Famine: An Exposition, mimeo, Indian Statistical Institute, April 2002. It is hoped that some of you will be inspired, decide to study economics further in college and eventually bag Nobel prizes for India. If the price of rice is p3 or higher no one can buy rice; but such a price cannot prevail in equilibrium and hence is irrelevant. We can instead draw a standard upward sloping supply curve. But this will not change the analysis.

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CLIP 5-1
By now Professor Amartya Sen is a household name in India. He was born in Santiniketan in 1933. He studied in Calcutta University and later got his Ph.D. from Cambridge University in 1959. Since then he has held faculty positions in various prestigious institutions at home and abroad such as Delhi School of Economics, Oxford University, London School of Economics and Harvard University. Currently, at this time of writing, he is the Master of Trinity College at Cambridge University. He has received more than forty honorary doctorates from major universities around the world, and the Bharat Ratna award, which is the highest civilian award in India. He has published numerous books and articles, and, his research has ranged over many areas of economics, particularly welfare economics, and philosophy. In awarding him the Nobel prize in 1998, the Royal Swedish Academy of Sciences said that he had made several key Amartya Sen contributions to the research on fundamental problems in welfare economics. His contributions range from axiomatic theory of social choice, over definitions of welfare and poverty indices, to empirical studies of famine.

A0, B0, and C0. This situation can be interpreted as normal, one in which there is no starvation or famine. Now suppose that, for some reason, say, because of a bad monsoon, there is less amount available, equal to M1. The equilibrium price is higher, equal to p1. Notice that at this price, the poorest cannot afford to buy any rice, but the other types can. We can think of this situation as starvation:

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

Fig. 5.6

FAD Theory of Famines

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

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

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

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5.7 ECONOMIC POLICY BY THE GOVERNMENT AND MARKET EQUILIBRIUM Not only is market equilibrium affected by the sources of demand and supply shifts considered earlier, it is influenced by various government policies as well. There are some policies, e.g., different kinds of taxes and subsidies, that change the market price indirectly via shifting the demand and supply curves. Sales taxes and excise taxes are common examples.18 These are called indirect interventions. There are other policies by which prices are fixed directly by the government; these are direct interventions. In what follows, we study direct interventions only. Price Control It is thought that if necessary items like sugar, rice, wheat etc. were left to the play of free market entirely, poor people

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

(a) Fig. 5.7


18

(b) Price Control and Price Support

19

For example, in Delhi, the sales tax on pastries in the financial year 2001-2002 was 8% and that on bicycles was 5%. In general sales taxes vary across states and range typically from 5 to 15%. Some commodities are totally exempt from sales taxes. This is similar to the famine theory discussed earlier.

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

the equilibrium price (P0), opposite to the price control case, the quantity supplied (P2S2) exceeds the quantity demanded (P2D2). There is always some surplus. Who buys the amount of surplus or excess supply, P2S2? It is the government by committing to buy the surplus at the pre-announced support price. It is noteworthy that while price control programmes are commonly observed in developing countries rather than in developed countries, agricultural price support programmes have been common in both groups of countries. However, many price support programmes are being phased out now in both developed and developing countries, because of their commitments made to World Trade Organisation as members.20

SUMMARY
l

l l

Excess demand pushes up the market price by causing competition among the buyers. Excess supply pushes down the market price by causing competition among the sellers. At the market equilibrium, there is no excess demand or excess supply and demand and supply curves intersect. A non-viable industry is one, in which the demand and supply curves do not intersect at any positive level of output. The supply curve lies above the demand curve and thus nothing is produced. A rightward (leftward) shift of the demand curve leads to an increase (a decrease) in price and quantity transacted.

20

While the intentions behind price control and price support programmes are well-meant, there is considerable debate in economics literature about their efficiency in achieving the objectives, in comparison to other policies that can achieve the same objectives. This is something that will be studied in specialised courses in economics. World Trade Organisation is an international body like United Nations, having more than 120 member countries, whose objective is to promote free and fair international trade and commerce in the world economy. It came to existence in 1995 and is headquartered in Geneva, Switzerland. India is a founding member of WTO. China joined WTO in 2001.

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l l

l l

l l l l l l l l

l l

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

EXERCISES

Section I
5.1 5.2 5.3 5.4 Give the meaning of excess demand for a product. Give the meaning of excess supply of a product. Define market equilibrium. Give the meaning of equilibrium price.

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5.5 5.6 5.7 5.8 5.9 5.10 5.11 5.12 5.13 5.14 5.15

For a non-viable industry, where does the supply curve lie relative to the demand curve? How does an increase in the price of a substitute good in consumption affect the equilibrium price? How does an increase in input price affect the equilibrium quantity exchanged in the product market? How does a favourable change in taste affect the market price and the quantity exchanged? How does a cost-saving technological progress affect the market price and the quantity exchanged? How does an increase in excise tax rate affect the market price and the quantity exchanged? When will an increase in demand imply an increase in price but no change in quantity supplied? What does the FAD theory of famines say? What is the relationship between the control price and the equilibrium price? What is the relationship between the support price and the equilibrium price? Why does a surplus emerge in case of a support price?

Section II
5.16 5.17 5.18 Show the determination of market equilibrium with the help of demand and supply schedules and a diagram. What is meant by economic viability of an industry? What will be impact on market price and the quantity exchanged when (a) there is a rightward shift in the demand curve ? (b) the demand curve perfectly elastic and the supply curve shifts out ? (c) both the demand and supply curves decrease in the same proportion ? How does an increase in the income affect the equilibrium price of a product? A severe drought results in a drastic fall in the output of wheat. Analyse how will it affect the market price of wheat. Suppose the demand for jeans increases. At the same time, because of an increase in the price of cotton, the supply of jeans decreases. How will it affect the price and quantity sold of jeans? Equilibrium price may or may not change with shifts in both demand and supply curves. Comment.

5.19 5.20 5.21

5.22

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5.23 5.24 5.25 5.26 5.27 5.28

5.29

5.30

5.31

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

Section III
5.32 5.33 Mrs. Ramgopal says that economists say inconsistent things: as price falls, demand rises, but as demand rises, price rises. Defend or refute. Describe the FAD theory of famines.

OTHER FORMS

OF

MARKET STRUCTURE

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CHAPTER

6
OF

OTHER FORMS

MARKET STRUCTURE

6.1 Perfect Competition in the Long Run: Free Entry and Exit 6.2 Monopoly 6.3 Monopolistic Competition

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

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6.1 PERFECT COMPETITION IN THE LONG RUN: FREE ENTRY AND EXIT Before analysing the implications of free entry and exit, we discuss a couple of things. 1. Recall from Chapter 3 that there are no fixed costs in the long run. Moreover, both the Long run Average Cost (LAC) and the Long run Marginal Cost (LMC) curve are U-shaped. The pattern of returns to scale that is, initially at low levels of output, a firm would experience increasing returns to scale, followed by constant returns to scale and diminishing returns to scale implies the U-shape of LAC curve, which, in turn, implies the U-shape of LMC curve. 2. How does producers equilibrium or profit-maximisation happen in the long run? The answer is that it happens the same way in principle as in the short run. Profit is maximised when P = LMC. The economic logic behind it is also parallel to that in the short run. We are now ready to examine the effects of free entry and exit. Suppose that the market price of the product is P1, and the firms are producing at the point where the price line intersects the LMC curve. Moreover, suppose that the price, P1, is high enough such that, at the profitmaximising level of output, firms are making positive profits. In economics, a positive profit is sometimes referred to as abnormal profit, in the sense that the total cost is assumed to

include not just the production costs but also the opportunity cost of the producer herself and hence profits are equal to the producers excess earning over her opportunity cost. (Likewise, negative profits, that is, losses are called abnormal losses.) In this situation, abnormal profits will attract many new firms to the industry. This will shift the market supply curve to the right, driving down the market price and profits. Another way to look at it is that there will be more competition, which will lower price and profits. How far will this continue? It will happen till there are no abnormal profits. Similarly, if, initially, the price is low enough such that firms are incurring losses, free exit means that some existing firms will start to quit the industry. This will tend to shift the market supply curve to the left. The price will rise. Losses will be less. The exit process will continue till there are no losses. It then follows that free entry and exit imply zero profit in equilibrium. Note that profit being zero is equivalent to P = LMC . This is the break-even price, the price at which the abnormal profit is zero. We can then say that free entry and exit imply that in the long run the market price will be equal to the break-even price. Together with the profit maximising condition P = LMC, the long-run competitive equilibrium is then defined by

P = LMC = LAC.

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

That is, the firm produces at a level (qL),where the LAC is at the minimum, i.e., production occurs at the most efficient scale. The firms scale of operation is large enough such that the benefits of increasing returns to scale have been realised, but it is not that large so as to incur the problems associated with decreasing returns to scale. 6.2 MONOPOLY Some of you must have heard this term before. Mono means one, poly means seller and thus monopoly means one seller. This is defined in the context of a given geographical location or space. In India, before liberalisation in the power sector got underway in the 1990s, the generation, transmission and distribution of electricity were in the hands of State Electricity Boards (SEBs). The SEBs were monopolies in the respective states. To take another instance, you hear many people use the term xeroxing

(a)

(b)

Fig. 6.1 Firm and Market Equilibrium in the Long Run

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CLIP 6.1
Patent Laws
Most developed countries have comprehensive patent laws. During the patent life the patent holder can sell license to other firms for using its technology (legally). Typically, the license is sold to firms who operate in markets other than where the patent holder operates, e.g., in a different country. The enforcement of patent law is also strict in developed countries. A patent holder can take to court some other firm, who may be using its technology without a license, and get a fairly quick decision. In India, the patent law and its enforcement are rather passive. This is because research and development, discoveries and inventions have not been a focus of activities by firms. Barring a few exceptions, we generally import technology from abroad. The most important patent legislation in India is the Indian Patent Act of 1970. It provided that any invention of a new product or a process of production, which is useful and not obvious, is patentable. But it explicitly did not allow product patents in the drug and food sector. This allowed Indian drug companies to produce drugs invented in the developed countries and sell them in less developed countries. Cipla, an Indian drug company, is an example. For a long time, Cipla has supplied antiAIDS drugs, named Combivir, to a country like Ghana. Recently however, as an obligation of being a member of WTO (World Trade Organisation), India and other countries had to revamp their patent laws. In India, a major amendment to the Patent Act of 1970 was done in 1999, by which both product and process patents are allowable in the food and drugs sector. In general, patents are being protected more aggressively than before. To continue our account of Cipla selling Combivir in Ghana, a multinational company named Glaxo Smith Kline claimed that it had patents on the generic version of drug Combivir and it filed a patent violation complaint against Cipla in Ghana. After the hearing of arguments by both companies, the government of Ghana in 2000 rejected Ciplas application to market this drug in Ghana. There is a fear in India that, because of our being a member of WTO, we are forced to honour patent protection. As a result, particularly in the drug sector, Indian companies will no longer be able to sell many essential drugs at affordable prices. Once multinational companies start to sell them, the drug prices are going to skyrocket, and many poor people will be denied access to these drugs. Are patents a good thing for a developing country like India? Should India be a member of WTO? An immediate reaction may be a no to both. However, a careful and rational thinking might suggest just the opposite. We recommend you to visit WTOs website, http://www.wto.org and read many articles on these issues.

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

products or new technology in producing an existing product. As a reward for their risk and investment in research, they can apply to their government for a patent, which is an of ficial recognition that they are the originators of the new product or technology and no one else can use their technology without obtaining license from them. In other words, monopoly arises because of granting patent certificate or what is called patent rights. The case of Xerox is an example.2 However, patents are not granted for ever. They are valid only for a certain number of years (after which other firms can freely copy the technology). This period is called patent life. In most developed countries the patent life varies between 15 to 20 years. In Australia it is 20 years; in the U.S. it is currently 17 years. See Clip 6-1 on patent laws. (c) Sometimes, fir ms retain their individual identity but they coordinate their outputs and pricing policy so as to act as if it is a monopoly. This is called a cartel. The OPEC (Organisation of Petroleum Exporting Countries) in the 1970s is an example of a cartel that led to virtual monopoly in the

Plain-paper photocopy machine has been regarded as the most successful commercial product in history. Now there are many well-known companies, besides Xerox, in the world market that produce photocopying machines, e.g., Canon, Mita, Panasonic, Ricoh, Royal, Sharp and Toshiba. Many fax machines also have copying capability. Another example is a drug company called Eli Lilly, which has a patent on a very widely used antidepressant called Prozac. This patent is supposed to expire in 2003.

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world market for oil. See Clip 6-2 for a brief history of the OPEC and the world oil market.3 6.2.1 Total, Average and Marginal Revenues The objective of a monopolist is to maximise its total profit, which, by definition, equals total revenue minus total cost. The cost structure facing a monopolist is similar to that of a competitive firm. We have the same concepts, total cost, average cost, marginal cost etc., and their general shapes are also the same as for a competitive firm. But the revenue structure facing the monopolist is quite different. Recall that a perfectly competitive firm is very small compared to the

market. It does not have any market power and thus it is a price-taker. None of this is true for a monopoly since it is the only producer by definition. It has market power and it is a price-maker so-to-speak. This is the most important difference of a monopoly firm from a perfectly competitive firm. It implies that the way total revenue changes as output changes is different from what happens to a perfectly competitive firm. In case of the latter, we already know that, as output increases, the price remains unchanged. But a monopoly firm faces the entire market, hence faces the market demand curve. Hence, as it increases or decreases its output it cannot expect that the market price remains unchanged: price will change according to what consumers are

Clip 6-2
OPEC and The World Oil Market
OPEC had five founding members: Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. It came into existence in 1960. Qatar joined it in 1961, followed by Indonesia and Libya in 1962, United Arab Emirates in 1967, Algeria in 1969 and Nigeria in 1971. In the 1970s when the first oil price shock overtook the world economy, OPEC consisted of the above-mentioned countries. (Currently there are two other countries in OPEC, namely, Ecuador and Gabon.) The aim of the OPEC countries is to set production quotas, so as to manipulate the price of petrol in the world market. Besides the OPEC, there are other countries which are major producers of oil. For example, America was and still is, a big producer of oil. But its consumption is even greater and thus it is an importer of oil. India also produces oil and is an importer. Hence, in the import-export market, OPEC in the 1970s can be interpreted as a monopoly. The oil shortage of 1970s motivated many other countries to explore oil. By mid 1980s there were other countries, who were major exporters of oil and who used to be importers of oil earlier, e.g., Mexico, The Netherlands and Russia.
3

There are other reasons for monopoly or near-monopoly also, e.g., merger and acquisition. In the early 1990s, in the tea industry, Brooke Bond and Lipton merged and subsequently they merged with Hindustan Lever. It left out Tata, another large tea firm.

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

demand schedule as in Table 6.1. Now, by multiplying output by price, we get the Total Revenue (TR), which are given in column (3). Dividing TR by output gives average revenue, AR, since, by definition, AR = TR/output. This is Table 6.1 A Demand Schedule Price (in Rs.) 1 3 5 7 9 11 13 15 Quantity Demanded (units) 7 6 5 4 3 2 1 0

shown in column (4). TR being equal to price output, AR = price output/ output = price, that is, AR is equal to price.5 Thus the entries in column (4) are same as those in column (2). Also recall from Chapter 4 the concept of Marginal Revenue (MR), defined as the addition to the total revenue from one extra unit sold. The last column gives the MR schedule.

Hence, unlike what many, especially non-economists, believe, a monopolist despite having market power, cannot not just charge any price at its sweet will. It could have, only if the demand curve were totally vertical, i.e., there were absolutely no substitutes available. But for most products substitutes are available. This is true except when output is zero. At zero output, TR/output = 0/0, which is not defined.

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We note the following properties of the three revenue concepts. 1. MR decreases with the output. Initially it is positive and after a Table 6.2 TR, AR and MR under Monopoly Output Price (Rs.) TR (Rs.) AR (Rs.) MR (Rs.)

0 1 2 3 4 5 6 7

15 13 11 9 7 5 3 1

0 13 22 27 28 25 18 7

13 11 9 7 5 3 1

13 9 5 1 -3 -7 -11

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

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

(a)

(b)
Fig. 6.2 The TR, AR and MR Curves corresponding to Table 6.2

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Fig. 6.3 depicts a smooth hypothetical TR curve and the associated AR and MR curves. As you can notice, TR reaches its maximum when MR = 0.

(a)

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

(b) Fig. 6.3 Smooth TR, AR and MR Curves

6.2.2Profit-Maximising Rule A full analysis of a monopolys profit maximisation or producers equilibrium is beyond our scope here. But we can state its condition:

MR = MC. That is, a monopolist maximises profit by selecting the level of output at which MR = MC. This is indeed a very general condition of profit maximisation by a firm. (It was noted in Chapter 4 also.) Recall that for a competitive firm MR = P and thus the condition P = MC is a special case of the general condition MR = MC.

(A)

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

The last point summarises what is wrong with a monopoly market structure. It is the basis of negative sentiments against a monopolist, which arises from time to time and which flares up to a slogan that a monopolist exploits the public and hence should be regulated and discouraged. 6.2.4 MERITS OF MONOPOLY But before we rush to this conclusion we should note some good things about the monopoly too. 1. Suppose that initially there are two firms in an industry and both are somewhat inefficient. Their MC curves are at a high level and consequently they charge a higher price and produce less than what they would if the MC curves were at a lower level. They realise, however, that if they merge with each other and thereby become a monopoly they can reduce their costs. For instance, one firm may have excellent technical manpower but may not have good marketing skills, whereas the other may not have good technical manpower but possesses superior marketing knowledge. By merging, the resulting monopoly firms MC curve will be at a lower level and thus it will be a more efficient firm. This, by itself, will induce the monopoly

However, it is quite possible and likely that over a long period the monopolist loses its monopoly power. For example, if the monopoly is present, in the first place, by virtue of a patent, the patent eventually expires and other firms use the same technology and there is competition. But the point is that as long as there is monopoly, there is little analytical difference between short run and long run in terms of output and price determination.

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

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

In India, the MRTP Act of 1969 is the land-mark anti-trust legislation. For example, at the point of writing this book, there are 7 brands of lipstick available in the Indian market: Avon, Elle, Lakme, Loreal, Maybelline, Revlon and Tips & Toes. There are many more brands of toothpaste, e.g., Acquafresh, Anchor, Amar, Babool, Cibaca, Close-Up, Colgate, Forhans, Meswak, Neem, Pepsodent, Promise and Vicco Bajradanti.

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

Although the features of monopolistic competition are a combination of perfect competition and monopoly, in terms of decision-making, there is one aspect of it, which is different from both perfect competition and monopoly. That is, monopolistically competitive firms typically engage in advertising, i.e., they incur advertising costs or what is also called selling costs. It is because of the need to maintain a perception in the mind of the potential consumers that their respective brands are different (and more tasteful or classy), compared to other brands. This is persuasive advertisement and its purpose is to lure away consumers from other brands. In perfect competition, the product is perfectly homogeneous and hence there is no scope to engage in persuasive advertisement. In monopoly, since there is no competition, there is no need to engage in persuasive advertisement. Realise that such selling costs do not benefit the consumers as a group: they only serve to move consumers one brand to another. But they involve resources, which can be potentially used for production. Therefore, such costs are wasteful from the viewpoint of the society.9 This closes our analytical discussion on market structure. As said in the beginning of this chapter, we leave out one important form of an imperfectly competitive market, namely, oligopoly. See Clip 6-3 for a brief description of oligopoly.

Not all advertising costs are wasteful. There can be informative advertising (e.g. information about health), which is useful for the consumers.

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CLIP 6-3
Oligopoly
A market in which there are a few (two or more) number of large firms is called oligopoly. (The firms in it may be producing a homogeneous product or a differentiated product.) As a special case, if there are only two firms, then it is called a duopoly market. From an analytical perspective, what distinguishes oligopoly from other market structures is strategic interaction among firms. Since there are only a few number of firms, a particular firm, in choosing its output or price, has to take into account what the other firms are choosing and how they may react to its choices. This is a subject matter of a higher course in microeconomics.

SUMMARY
l l

l l l l l l l l l l l l l l

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

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A monopolistically competitive firm typically faces a very elastic demand curve for the brand it produces. The long run equilibrium in monopolistic competition is characterised by the conditions, MR = LMC and P = LAC. Monopolistically competitive firms engage in advertising costs to lure away customers from other brands to their own brands. EXERCISES

Section I
6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9 6.10 6.11 6.12 6.13 6.14 6.15 6.16 6.17 6.18 6.19 Name the three forms of imperfectly competitive markets. What is the profit-maximising condition of a competitive firm in the long run? What is meant by abnormal profit? What is meant by abnormal loss? If the firms are earning abnormal profits, how will the number of firms in the industry change? If the firms are making abnormal losses, how will the number of firms in the industry change? What is the relationship between marginal cost and average cost at the long run competitive equilibrium? State the conditions of long run equilibrium in a perfectly competitive industry. What is break-even price? What is the relationship between break-even price and marginal cost at the long run competitive equilibrium? Which point on the long run average cost curve does a competitive firm produce in the long run equilibrium? How many firms are there in a monopoly market? What are patent rights? What is patent life? What is a cartel? How does the total revenue change with output when the marginal revenue is positive? How does the total revenue change with output when the marginal revenue is negative? What is the relationship between the average revenue curve and the demand curve in a monopoly market? What is the profit-maximising condition for a monopoly firm?

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6.20 6.21 6.22 6.23 6.24 6.25 6.26 6.27 6.28 6.29 6.30 6.31 6.32 6.33 6.34

What is the shape of the total revenue curve in monopoly? What is the shape of the average revenue curve in monopoly? What is the shape of the marginal revenue curve in monopoly? What is the profit-maximising rule for a monopolist? What is the relationship between price and marginal cost at the monopoly equilibrium? How do the equilibrium monopoly output and price compare with the equilibrium price and output in perfect competition? What are anti-trust legislations? Which feature/features of monopolistic competition is/are monopolistic in nature? Which feature/features of monopolistic competition is/are competitive in nature? Give two examples of a monopolistically competitive market? State the conditions of long run equilibrium in a monopolistically competitive industry. What is the relationship between price and marginal cost in a monopolistically competitive market? What are selling costs? What are advertising costs? What is persuasive advertising?

Section II
6.35 Explain how in the long run equilibrium with free entry and exit, firms, under perfect competition, earn zero abnormal profits. Explain why the marginal revenue is less than average revenue for a monopoly firm. Explain how the market demand curve is a constraint facing a monopoly firm. Discuss various ways in which a monopoly market structure may arise. Explain how the efficiency may increase if two firms merge. Explain the motivation behind granting patent rights. Briefly discuss the features of monopolistic competition. Why is the demand curve facing a monopolistically competitive firm likely to be very elastic? Explain how price exceeds marginal cost in monopoly or in monopolistic competition.

6.36 6.37 6.38 6.39 6.40 6.41 6.42 6.43

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6.44

Explain how in the long run equilibrium with free entry and exit, firms, under monopolistic competition, earn zero abnormal profits.

Section III
6.45 The demand schedule facing a monopoly is given below. Derive its TR, AR and MR schedules. Price (Rs.) 0 10 20 30 40 50 60 70 6.46 Quantity Demanded (units) 8 7 6 5 4 3 2 0

The MR schedule of a monopoly firm is given below. Derive the TR and AR schedules. Output (units) 0 1 2 3 4 5 6 7 MR (Rs.) 14 10 7 5 0 3 5

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6.47

The technology is such that the long-run average cost is minimised at the firm output equal to 10 and the minimum longrun average cost is Rs. 15. Suppose that the demand schedule for the product is given as follows.

Price (Rs.) 10 12 15 18 20 (a)

Aggregate Quantity Demanded 1800 1440 1200 1000 760

6.48

What will be total quantity sold in the market and how many firms will operate in the long run competitive equilibrium? (b) Suppose that, because of technological progress, the average cost curve shifts down such that the minimum average cost is equal to Rs. 12 and it occurs at output level 8. How many firms will now operate in the market in the long run? Explain why MR = MC is the profit-maximisation principle of a firm in general.

U N I T-V
FACTOR PRICE DETERMINATION

FACTOR PRICE DETERMINATION

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CHAPTER

FACTOR PRICE DETERMINATION

7.1 Factor Demand

7.2 Total Factor Demand, Factor Supply and Equilibrium

7.3 Trade Unions

In Chapter 2 to Chapter 6, we examined the product markets: which good or service will be produced, and if so, how much and what its price will be. In other words we dealt with the central problem of what facing an economy. Households are demanders and firms are suppliers in product markets. In this chapter we examine factor or input markets, e.g., different types of labour or skill, capital (i.e. machinery and equipment), land etc. In factor markets, firms are demanders and households are suppliers. There are similarities and dissimilarities between product and factor markets. Dissimilarities arise because the demanders and suppliers in a factor market are opposite of who they are in a product market. The issues are different also. Instead of the economys central problem of what, the factor market analysis sheds light on the for whom problem. For example, consider the labour market. The price of labour service is the wage rate. We will learn how the wages to different types of labour are determined in a market economy. In general, earnings to different individuals in the form of wage income or income from land etc. determine income distribution in an economy. Income distribution, in turn, determines differences

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

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

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of a factor, when the employment of other factors is unchanged. The latter is the increase in total output per unit increase in the employment of a factor when the employment of all other factors is held constant. From Chapter 3, we also know the shapes of the TPP and MPP curves. In particular, the inverse U-shape of the MPP curve follows from the law of diminishing returns. We need two more concepts before we are able to answer in principle the question of how much of a factor a profit-maximising competitive firm will employ. The first is the Total Value Product (TVP), defined as P TPP, where P is the product price. This is indeed same as total revenue. The Table 7.1 Labour Hours (L) 0 1 2 3 4 5 6 7 8 9

second one is the Value of the Marginal Product (VMP), defined as P MPP. Equivalently, VMP is equal to the increase in TVP or total revenues per unit increase in the employment of the factor. It is because an extra unit employed of a factor generates extra output equal to MPP, which will fetch extra revenues equal to the value of this extra output. Consider the TPP schedule and the MPP schedule, as given in Tables 3.2 and 3.3 in Chapter 3. In order to calculate the TVP and the VMP, we need to know the product price. Suppose that P = Rs. 2. Table 7.1 gives the TPP schedule, the MPP schedule as well as the associated TVP and VMP schedules.

TPP, MPP, TVP and VMP Schedules MPP 10 12 11 10 8 5 0 8 12 Product Price = Rs. 2 TVP = P.TPP (Rs.) 0 20 44 66 86 102 112 112 96 72 VMP = P.MPP (Rs.) 20 24 22 20 16 10 0 16 24

TPP 0 10 22 33 43 51 56 56 48 36

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

(a)

(b) Fig. 7.1 The VMP Curve

competitive firm by definition, a small firm hires in the labour market. The point to note for us is that the area under the factor price line is the total factor cost or payment to the factor. If, for instance, the firm hires L1 labour hours, its total wage bill is the area 0WCL1.

Fig. 7.2 Factor Price Line

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

Fig. 7.3 Factor Employment Decision

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

0W0 CL0. Thus the gross profit, which is the difference between TVP and total factor cost, is equal to the area W0 AC.1 Now consider any employment level less (such as LA) or more (such as LB) than L0. We can compute that the profit is less than W0 AC. For instance, at L = LA, it is equal to W0 AFD, which is equal to W0 AC CDF. At L = LB, it is equal to W0 AC CEG. This proves that profit is maximised at L = L0. The law of diminishing returns is the key. Starting from where the VMP of a factor is equal to its price and the MPP is diminishing, if the firm hires one extra unit of the factor, the VMP will be less than the factor price. This is same as saying that the additional revenue generated (equal to VMP) is less than the additional cost incurred (equal to the factor price). This implies less profit than before. Similarly, if the firm hires one less unit than where VMP is equal to the factor price, the VMP will be higher than the factor price. As a result, the revenue sacrificed (equal to VMP) by hiring one unit less will be more than the savings on the total factor cost (equal to the factor price). Thus profit will be less. In summary, under diminishing returns, any deviation from the principle (A) will only generate less profit. This proves why profit is maximised when condition (A) is met.

The adjective gross is attached, since fixed costs are not deducted. By definition, profit = gross profit fixed cost. However, since the fixed costs are given, gross profit is maximised where profit is maximised and vice versa.

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

Fig. 7.4 Product Price Increase and Factor Demand

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

This is parallel to the supply curve of a firm being same as the upward sloping portion of the marginal cost curve.

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(a) Technological Change increasing the


MPP of a Factor

such that the MPP of a factor increases, then the demand curve for that factor shifts to the right. Fig. 7.5(a) shows this effect. Otherwise, if the MPP of a factor decreases due to a technological change, then its demand curve shifts to the left. Fig. 7.5(b) illustrates this. For example, it is widely believed by economists that, in recent two/three decades, the whole world economy has experienced technological progress that has increased the MPP of skilled labour. Whether it has increased the MPP of unskilled labour is not clear.3 7.1.3 Marginal Productivity Theory of Distribution So far we have assumed that the firm employs only one variable factor of production. In reality, firms employ many, e.g., different types of labour, raw materials, power, various kinds of machines, land etc. What are the (profit maximising) principles that govern the simultaneous demand/ employment of more than one factor? They are simply the extensions of the condition (A). If, for example, there are two factors, say X and Y, their respective prices are WX and WY, and their respective marginal products are MPPX and MPPY, the profit-maximising principles are: (A') VMPX = P.MPPX = WX , VMPY = P.MPPY = WY.

(b) Technological Change lowering the MPP


of a Factor

Fig. 7.5

Technological Change and Factor Demand

Technological Change A technological change can alter the MPP of a factor and thereby its demand curve, even when the product price is unchanged. If it is
3

Another possible source of a shift in the factor demand curve, which we have not discussed and which is something to be done in a higher course in microeconomics, is the change in the employment of other factors.

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

7.2

TOTAL FACTOR DEMAND, FACTOR SUPPLY AND EQUILIBRIUM

WX WY

P .MPPX P .MPPY

MPPX . MPPY

Hence, if MPPX > MPPY, then WX >WY . That is, skilled labour earns more than unskilled labour.
4

In principle, factor prices should be determined by forces of demand and supply both, not just by demand forces that we have emphasised so far. However, when we do take into account the supply side, the marginal productivity theory does hold, with appropriate interpretation. In order to see this and analyse factor market equilibrium in general, let us return to the one-factor case. We have derived a single firms demand for a factor. There are many fir ms in a per fectly competitive industry. So, if we sum up the demand for a factor across various firms, we get the total industry demand curve for that factor.4 However, some factors are used in many industries and in that case, the total demand curve for a factor is the horizontal summation of individual (firm) demand curves for that factor in various industries combined. In Fig. 7.6(a) and (b), the total demand for a factor is shown as the line DD. 5 We now turn to the supply side. Consider, for example, teaching service as a factor of production (in producing education). If the salaries of school teachers increase, more people than before will be willing to choose school

The derivation of total demand for a factor is more complicated than the derivation of market demand curve for a commodity. This complication arises due to a change in the price of the commodity when all firms increase or decrease their outputs together. To simplify the discussion, the price of the commodity is implicitly kept constant during this summing up. How DD is derived is parallel to how the product market demand curve is derived from individual demand curves.

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

(a) Short Run

(b) Long Run Fig. 7.6 Demand, Supply and Market Equilibrium of a Particular Skill

Thus the land market equilibrium is similar to that of a particular skill. Fig. 7.6 applies except that rent substitutes the wage rate and land substitutes labour. A point to note here is that, if we interpret land narrowly in terms of area on ground, the supply of land to a particular industry is upward sloping (in the long run), but land supply to the entire economy is given.7

In the present context this is the price of land in terms of its service as a factor of production. It is different from price of land as an asset. There are exceptions. Countries like Japan and Hong Kong have claimed land from sea.

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

point, from the demand side, the factor reward is equal to the value of its marginal physical product. Thus the marginal productivity theory holds when the marginal physical product is evaluated at the equilibrium quantity of the factor service that is in use. 7.3 TRADE UNIONS

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

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

Fig. 7.7 Trade Unions and Unemployment

Thus, unemployment sometimes may be caused by the presence of trade unions.

SUMMARY
l l l l l l l l

A factor service is demanded by firms and supplied by households. Factor price is determined by forces of demand and supply of a factor. For a competitive firm, the VMP curve of a factor is generally inverse U-shaped. This is because of the law of diminishing returns. For a competitive firm, TVP of a factor is equal to the area under its VMP curve. The total factor cost or payment to a factor is the area under the factor price line. For a competitive firm, profit maximisation occurs when each factor is paid its VMP. The demand curve for a factor is essentially the downward sloping portion of its VMP curve. An increase in the product price shifts out the demand curve of a factor. In this sense, the demand for a factor is derived demand.

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The MPP of a factor and hence its demand curve can shift because of technological changes. Marginal productivity theory implies that different factors are paid differently because of differences in their VMPs. Skilled labour is paid more than unskilled labour because the marginal product of former is higher than that of the latter. The total demand curve for a factor is the horizontal summation of individual (firm) demand curves for that factor. The supply curve of a factor is upward sloping in the long run, but it may be vertical in the short run. Capital, as a factor of production, is different from land in the sense that, unlike land, it is typically reproducible. An increase in the demand for a factor tends to increase its price, while an increase in the supply of a factor tends to lower its price. When a labour union fixes a wage above the market-clearing wage, unemployment results in the labour market. It is because, at a higher wage rate, firms employ less labour, while the supply of labour by workers may increase or remain unchanged.

EXERCISES

Section I
7.1 7.2 7.3 7.4 7.5 7.6 7.7 7.8 7.9 7.10 7.11 7.12 7.13 Who are the demanders in the factor markets? Who are the suppliers in the factor markets? To which central problem does the problem of factor pricing relate to? How are TVP and TPP of a factor related? How are VMP and MPP of a factor related? What is the difference between MPP and VMP of a factor? How is the TVP of a factor derived from its VMP curve? What happens to TVP of a factor when its VMP is positive? What happens to TVP of a factor when its VMP is negative? How is the total payment to a factor derived from the factor price line? What is the relationship between the VMP curve and the factor demand curve? Name two factors responsible for a shift in the factor demand curve. What is the relationship between the wage rate that a labour union typically fixes and the equilibrium wage rate?

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Section II
7.14 The TVP at the employment level L = 4 is 50 units. That at L = 5 is 65 units. The price of the product is Rs. 3. What is the MPP at L = 5? The product price is Rs. 5. The TPP schedule of a factor is given in the following table. Derive its VMP schedule. Employment of a Factor 0 1 2 3 4 5 6 7 8 7.16 TPP (units) 0 8 20 32 42 50 56 60 62

7.15

7.17

7.18 7.19 7.20 7.21 7.22

The total payment to a factor is Rs. 12,000. The price of the factor is Rs. 40. How many units of that factor are being employed? Suppose that the product price is Rs. 10 and a factor is paid Rs. 70 per unit. The law of diminishing returns holds. At some level of employment, MPP = 5. Show that, at this level of employment, profit is not being maximised. Should the firm increase or decrease employment in order to increase its profits? Explain why a factor demand is called derived demand. What does the marginal productivity theory of distribution say about the earnings of different factors? Explain why skilled workers earn more than unskilled workers. How does an increase in the supply of a factor affect its earning (price)? Unfortunately an earthquake hits a town and destroys many residential flats, which were used for renting. All other things

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7.23

remaining unchanged, will this affect the demand curve or the supply curve of residential flats for rent and how? How will it affect the rental rate per month? Suppose that technological advance takes place in such a way that the MPP of skilled labour increases. How will it affect the wage of skilled labour? Further suppose that the technology advance lowers the MPP of unskilled labour. How will it affect the wage of unskilled labour?

Section III
7.24 7.25 Explain how profit is maximised when the VMP of a factor is equal to its price. Explain why, under perfect competition, the VMP curve for an input is considered its demand curve.

COMPARATIVE ADVANTAGE, INTERNATIONAL TRADE

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FACTOR MOBILITY

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CHAPTER

COMPARATIVE ADVANTAGE, INTERNATIONAL TRADE AND FACTOR MOBILITY


8.1 Ricardo's Theory of Comparative Advantage and Benefit from Trade 8.2 Factor Endowment Theory of International Trade 8.3 Factor Mobility

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

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

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

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

This is written more compactly in Table 8.1. Table 8.1 Labour Coefficients India Cricket Bats Footballs 10 20 Australia 15 60

We will make a number of simplifying assumptions so as to clearly bring out the essence of this theory. Assume that there are two countries in the world: India (N) and Australia (A). Each can produce two goods, say, cricket bats and footballs. Perfect competition prevails in the market for each good. There is one factor of production, say, labour (L). Each country is endowed with a given supply or what is called endowment of labour, say LN = 100 and LA = 120 respectively for India and Australia. Furthermore, the labour required to produce one unit of output, or what is called the labour coefficient, is given in each sector. As a numerical example, suppose that Producing 1 cricket bat in India requires 10 units of labour Producing 1 football in India requires 20 units of labour Producing 1 cricket bat in Australia requires 15 units of labour. Producing 1 football in Australia requires 60 units of labour
1

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

In turn, this means constant marginal physical product of labour.

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

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

In order to see how international trade makes a difference, suppose that initially there is no trade between the

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(a) India

(b) Australia

Fig. 8.1 The Production Possibility Curves

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

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

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

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

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1 football for 5 cricket bats. Then, in both countries, a football fetches more than it fetches in the no-trade situation and thus both would like to export football. But this is not possible, since there is no third country they can both export to: by definition, the two countries comprise the world economy. (When there are more than two countries, you can group them into the home country and the rest of the world and the same argument holds.) You can similarly argue that if the world terms of trade are 1 football for something less than 2 cricket bats, both countries would want to import football and that is not possible. This proves that the equilibrium world terms of trade will lie between the domestic exchange ratios. Assume that the world terms of trade lie strictly in between the two domestic exchange ratios. As an example, suppose that they are equal to 1 football for 3 cricket bats. Specialisation Now think about how much of each good will be produced in the two countries. From the viewpoint of India, the relative price of football is 3 cricket bats, which is greater than its the marginal opportunity cost (equal to 2 cricket bats). This will mean that there are abnormal profits in the football sector. Hence resources (labour) will move out of the cricket bat sector to the football sector. This process will continue until there is no production of cricket bats in India. That is, India specialises in football, i.e. produces

football only. Mark that football is the good, in the production of which India has comparative advantage. By similar argument, Australia specialises in cricket bats, in which it has comparative advantage. Specialisation occurs as the world terms of trade are different from the domestic exchange ratio. This is shown in fig. 8.2, which graphs the same PPCs as in fig. 8.1 (shown by the dashed lines). Indias and Australias production points in free trade are shown at points D and H respectively. We can then summarise that in the Ricardian world economy, as long as the world terms of trade differ from the domestic exchange ratio, a trading country specialises in the good, in the production of which it has comparative advantage. This is how international trade affects production and resource allocation in an economy. Consumption Possibilities Now we come to the last stage of our discussion. What are the consumption possibilities facing the two countries and how do they benefit from trade? But before we address this question, we should know what we mean by exports and imports. Exports of a commodity are equal to its production minus its consumption, whereas imports of a commodity are equal to its consumption minus its production. In other words, if a good is exported (imported), then its production exceeds (falls short of) its consumption in the country.

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(a) India Fig. 8.2

(b) Australia

Free International Trade in the Ricardian Economy

In fig. 8.2, since India produces at D, one consumption possibility for her is the point D itself. But there are other possibilities. For instance, it can export one football in exchange for 3 cricket bats (all imported), or 2 footballs in exchange for 6 cricket bats (all imported) and so on. These possibilities give rise to the heavy line DE', whose slope is 3, equal to the relative price of football in the world market. 2 Put differently, the consumption possibility curve for India at the world terms of trade, equal to 1 football for 3 cricket bats, is the heavy line DE'. This situation is surely a better proposition for India than no trade, which only offered the consumption possibilities along the PPC

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

The concept of slope of a straight line is explained in Appendix 2.

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

that brings out this point is called the factor endowment theory.3 View the world as having two countries once again, say, India (N) and America (A). They produce two goods: Chairs (C) and Medicine (M). Instead of one factor of production, suppose that there are two, labour and capital. They are required in producing each of these two goods. There are constant returns to scale. Furthermore, the technology of producing either good is same between India and America and the production of chairs is relatively labourintensive and that of medicine is relatively capital-intensive.4 All markets are perfectly competitive. Suppose that the supply of each factor in each country is given. We can call these factor endowments, just like labour endowment in the Ricardian theory. 8.2.1 Factor Endowment Difference Let LN and KN denote the endowments of labour and capital in India. Likewise, let L A and KA denote the endowments of labour and capital in America. These are absolute factor endowments. The ratio of absolute endowments is called the relative factor endowment. For example, LN/KN is the relative endowment of labour in India. Having defined relative endowment, we can always compare it between countries. In our example, we say that

It was formulated originally by two Swedish economists, Eli Heckscher and Bertil Ohlin, and is called the Heckscher-Ohlin theory. It is not that the technology cannot differ between countries. But the idea here is to suppress such difference and focus on difference in factor endowments.

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India is the relatively labour-abundant country and America is the relatively capital-abundant country, if

( A)

LN KN

LA .5 KA

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

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

For example, let LN = 1, 500, KN = 500, LA=2,000 and KA = 1000. Then LN/KN = 3, LA/KA = 2, and thus L N/K N>L A/K A.

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

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

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

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

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

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

Fig. 8.3 Urban and Rural Wage for Daily Labour

We note that this is true not just for unskilled labour but also for skilled labour. Skilled workers want to move out of countries like India and China to the U.S. and Europe in order to earn higher wage for their skill. Similarly, capital, which earns less rental in capital-abundant developed countries, has an incentive to move (through multinational firms) to capital-poor, high-rental, developing countries. We should carefully note however that absolute factor price difference is only an immediate cause or an indicator of factor movement. Regional differences or differences between countries in demand and supply conditions of factors are the underlying cause of factor movement.

SUMMARY
l l l

The principle of comparative advantage implies that countries can benefit from trade by exploiting their differences. In the Ricardian theory, differences in technology form the basis of comparative advantage. Average physical product a factor is the inverse of its coefficient.

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l l l

l l l l l

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

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EXERCISES

Section I
8.1 8.2 8.3 8.4 8.5 8.6 8.7 8.8 8.9 What is meant by international trade? Give one example of international trade in services. What is meant by labour coefficient? Give the meaning of absolute advantage. Give the meaning of comparative advantage. What does the Ricardian theory emphasise as a basis of comparative advantage? In the Ricardian theory, which good does a country specialise in free trade? In the no-trade situation, what is the relationship between a countrys PPC and its consumption possibility curve? In the Ricardian theory, in the free-trade situation, what is the relationship between a countrys PPC and its consumption possibility curve? What does the factor endowment theory emphasise as a basis of comparative advantage? What is meant by relative factor endowment difference? What is meant by relative factor price difference? What is meant by absolute factor price difference?

8.10 8.11 8.12 8.13

Section II
8.14 8.15 8.16 Give two examples of international trade in services. Explain the concept of comparative advantage by using a suitable example. Explain that, in a two-country Ricardian world economy, both countries cannot have comparative advantage in producing the same good. Explain how, in the Ricardian world economy, constant labour coefficients imply that the PPC is a straight line. In an economy, there is one factor of production, labour. Two goods are produced: sitar and guitar. 5 units of labour is required to produce one sitar and 12 units of labour is required to produce one guitar. Determine the domestic exchange ratio between sitars and guitars in this country. The following table gives labour coefficients in the two sectors in two countries. Determine which country has absolute advantage and comparative advantage in which good.

8.17 8.18

8.19

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Popland Sitar Guitar 8.20 50 60

Rockland 60 50

8.21

8.22 8.23 8.24 8.25 8.26 8.27 8.28 8.29

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

8.30 8.31

Give two instances where factors are mobile. Name two labour-intensive commodities in India.

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8.32

Suppose the supply of workers for household services declines in the economy. How will it affect the urban and rural wage for these services?

Section III
8.33 8.34 8.35 Explain why a relatively labour-abundant country will export relatively labour-intensive goods. Analyse why daily wage is higher in urban areas than in rural areas. Suppose that many of our computer professionals migrate to foreign countries. Ceteris paribus, how will it affect the salary of computer professionals in India and abroad?