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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 India’s 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 economy’s 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.

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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, doctor’s 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).

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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.

This is because resources are scarce. if the economy is producing 50 lakh saris. the Table 1. (1. Not surprisingly.INTRODUCTION TO ECONOMICS 7 (Assume that all cricket bats are of the same quality and so are saris.8 This gives rise to a curve as shown in fig. 75 lakh saris can be produced (within. Most likely there will be other possibilities which are “intermediate”. Formally. Assume that the same resources can produce cricket bats also. Equivalently. it can produce. As more resources go into one sector and produce more. Table 1. say.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 8 0 1 2 3 4 5 75 70 62 50 30 0 An introduction to graph plotting and joining points is given in Appendix 1. suppose that 5 thousand bats can be made. it is defined for a “two-good” economy. 1. 1. (Ignore panel (b) for the moment.1(a). and.) It measures one good along the x-axis and the other on the y-axis.1.1(b). it shows various combinations of the two goods that can be produced with available technologies and with given resources. This is how a production possibility curve (PPC) is normally exhibited. say. less is available for other sectors and they will produce less than before. These are two production possibilities and both are rather extreme. all resources are employed in producing cricket bats. then we get a smooth curve as shown in fig.) 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. 70) etc. instead. (0. which are fully and efficiently employed. more realistically. not just 6 as in Table 1. and join the line segments. If we consider an economy in which. 75). For instance.1 summarises the various production possibilities that are available to the economy. there are numerous production possibilities. namely. . a year). This is the production possibility curve of our hypothetical economy. If. you see that as the production of one good increases that of the other falls. 3 thousand cricket bats. Let us now plot these possibilities.

The rate of this sacrifice is called the marginal opportunity cost of the expanding good.8 INTRODUCTORY MICROECONOMICS PPC shows the maximum amount that can be produced of one good. e. we cannot. Hence.2. the marginal opportunity cost of cricket bats is equal to 8 lakh saris. 1. Moreover. assuming that the economy is operating on the curve. Go back to Table 1.1 Production Possibility Curve PPC is downward sloping. although PPC is defined in the context of a two-good economy. machines or plants are kept idle).g. A (a) India) or resources work inefficiently (e. Increasing Marginal Opportunity Cost and the Shape of the PPC (b) Fig. because more production of one good is associated with less of the other. given the amount produced of the other good. It should be clear however that. more production of one good means some sacrifice of the other good.1. the The concept of “downward sloping” is explained in Appendix 1. 1. It only shows the possibilities. For example. It depends on preferences and tastes of individuals in the economy. It illustrates the maximum production capabilities of an economy at a given point of time. the idea behind it is general and holds for any number of goods. an economy cannot operate at any point outside of the PPC. The economy may not be even operating on the curve. without further information. . You should realise that. at the production possibility C. when 3 thousands bats are produced.1 Marginal Opportunity Cost. if there is unemployment (as true for a country like 9 We already know that. by definition. 70 – 62 = 8 lakh saris need to be forgone.1(b)).g. (see fig. Starting from possibility B.9 Note that the PPC does not show or say which point the economy will actually operate on. Similarly. 1. then the economy will operate strictly within the PPC. such as at point H. say the exact point of operation. if the production of cricket bats increases by one unit (to 2). along a PPC. at point G.

as more and more of a good is produced. it is a very important notion in economics. instead. and. Why does the marginal opportunity cost increase? The economic reason is that. We observe that.2 is an expanded version of Table 1. 1. Generally. and. 8 lakhs. 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 . Hence more and more of the other good has to be sacrificed to ensure a unit (given) increase of the former good. As an illustration. Typically however. 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. the PPC will be a straight line. if the marginal opportunity cost were constant. as the production of cricket bats increases. 8 to 12 and so on). If.1 and lists the marginal opportunity cost of cricket bats. factors producing it become marginally less and less productive. an important example of this will be studied in Chapter 8.2 Increasing marginal opportunity cost implies that the PPC is concave to the origin. by constructing an example. the marginal opportunity cost of a particular good on the PPC is increasing and therefore the PPC is concave [as shown in fig. Table 1.2. so on. suppose that you are a doctor having a private clinic in New Delhi and your annual earnings are Rs. Note that “marginal” means “additional”. You will see repeated use of it in later chapters.1(b)]. Finally. the marginal opportunity cost were decreasing. Table 1. These numbers are indicated in column (3).2 Opportunity Cost – A More General Concept The concept of opportunity cost is very important and universal . you can check.INTRODUCTION TO ECONOMICS 9 marginal opportunity cost (per thousand bats) is 12 lakh saris.not specific to PPC. the opportunity cost of a given activity is defined as the value of the next best activity. There are two other alternatives to having a clinic in New Delhi. 1. Most generally. its marginal opportunity cost increases (from 5 to 8. that the PPC will look convex.

and therefore. earning Rs. In the context of PPC. hair-cut.10 INTRODUCTORY MICROECONOMICS in New Delhi. 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. which will be derived from economic considerations. which would have generated an annual income of Rs. called microeconomics and macroeconomics. the sizes of unskilled and skilled labour force etc.2. 4 lakhs because you forego an income of Rs. 1. If you own a barber shop. 4 lakhs from the second best alternative of working in a government hospital. 1. such as from AC to FH in fig.2 Shift of the PPC 1. but not exclusively. That is. Out of them. 3 lakhs. It will be good idea for you to go through Appendix 1 thoroughly now. The former refers mostly. if the technologies progress or if the resources available to an economy (such as different types of equipment. Over time. the opportunity cost of (additionally) producing one has to be defined in terms of the only remaining good. and. although a given PPC shows that. Then your opportunity cost of having a clinic in New Delhi is Rs. 1. and analytical concepts like PPC and opportunity cost. you should not however think that an economy can never produce more of all goods. Note that. 4 lakhs annually. the (maximum) production of the other must fall.2. it has many branches or sub-disciplines. then the economy can produce more of both goods. or you can open a clinic in your home town. to the analysis of scarcity and choice problems facing a single economic unit such as a producer or a consumer.3 MICRO VERSUS ECONOMICS MACRO Fig. if you have not done so already. Microeconomics deals with the principles behind such choices. . So far we have discussed in general what economics is about. Consider an example of producing a service say. given your monthly pocket money. there are only two goods. the PPC can shift to the right. how many ice creams and chocolates you are going to buy? These are questions of individual choice. It may be noted at this point that the following chapters contain many analytical constructs or curves (like PPC). Mumbai. there are two core branches. The discipline of economics is vast.) grow.3 Shift of the PPC We now return to our discussion of the PPC. if the production of one good goes up.

Equally or probably more serious is the problem of individual incentives. as there was little reward for it. 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. On the other hand. which is essential for inventions and to voluntarily “work according to one’s ability”. The capitalist system has its serious problems too. the means of achieving them in the former suffers from two inherent flaws. (a) lack of coordination and (b) lack of individual incentives. i. And a failure to achieve the targeted level of production in one sector will create problems for many other sectors. “Work according to one’s ability” remained only an ideal. A modern economy produces millions of different kinds of goods and services. the market economy provides an opportunity and incentive for individuals to take risks. employment. there is little incentive to discover new or better quality products. This book is designed to cover some basic principles of microeconomics. improvement of standard of living of people.. 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. inflation etc. macro economics deals with the behaviour of aggregates such as real Gross Domestic Product (GDP). Obviously. They do not imply that direct government control over most economic activities in the economy – as in centrally planned economies – is the right solution. but only in selective and discrete ways. Also. a central coordination of activities in all or most of these sectors is bound to fail because of unanticipated events or just human error. Even the Chinese economy that used to be centrally planned is moving vigorously towards a market system today. .broke down in the late 1980s. i. guranteed life-time employment in the government-run industries or businesses provided no incentive to work sincerely or efficiently. namely. Individual freedom is respected and rewarded definitely more so than in a centrally planned system. Fluctuations. periodic recessions or depressions. Such problems call for government restrictions. are problems of one kind. Profit-oriented businesses may disregard the adverse impact of industrial activity on local or global environment.e.e.. CLIP 1-2 Capitalism Versus Central Planning* We all know that the Soviet Union – along with its economic system .INTRODUCTION TO ECONOMICS 11 On the other hand. * We need not mention NET in every clip. 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.

the production possibility curve is concave to the origin. What is microeconomics? What is macroeconomics? . The “how” problem refers to the choice of methods of production of goods and services. In a capitalist or market-oriented economy. A production possibility curve shifts out due to technological progress or increases in the supply of resources available to an economy or both.4 1. “how” and “for whom”.7 1. Define the production possibility curve. namely. Normally. Economics is concerned with the study of individual and social choice in situations of scarcity.1 1. What does increasing marginal opportunity cost along a PPC mean? Define opportunity cost. The “for whom” problem concerns with the distribution of income and wealth.8 What is economics about? Name any two central problems facing an economy.5 1. Define marginal opportunity cost along a PPC. There are three central problems facing any economy.2 1. The “what” problem refers to which goods and services will be produced in an economy and in what quantities. EXERCISES Section I 1.6 1. “what”. It is because of increasing marginal opportunity cost.12 INTRODUCTORY MICROECONOMICS SUMMARY l l l l l l l l l Economics is a social science. these problems are addressed through the operation of markets.3 1.

) .000 68. (The two “goods” here are (i) mathematics questions practised and (ii) social science questions practised. The following table summarises its production possibilities. Derive your production possibility schedule and plot it. 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 “for whom” with examples.19 Cell phones (in thousands) 90.” Explain. You have 8 hours to study.000 10.16 1.13 1.18 1. Calculate the marginal opportunity costs of T-shirts at various combinations. while you are not that good in answering such questions in social science: 12 questions per hour.12 1. You are very good at answering multiple choice questions in mathematics: 20 questions per hour. Kheti Lal in the text.000 Draw the production possibility curve for the example of Mr. Explain the central problem of “how” with examples.14 1.000 34. Suppose you have to practice question-answers for two subjects: mathematics and social science.10 1.000 52. Explain the central problem of “what” with examples.9 1.17 Explain how scarcity and choice go together.11 1. ‘‘Economics is about making choices in the presence of scarcity.15 1.INTRODUCTION TO ECONOMICS 13 Section II 1.000 80. T-shirts (in millions) 0 1 2 3 4 5 1. Why does the PPC look concave to the origin? An economy produces two goods: T-shirts and cell phones.

) “Massive unemployment shifts the PPC to the left. 3 lakhs annually.” Defend or refute.25 1. Section III 1. Plot the PPC in a graph paper and verify that it is concave to the origin.22 1.24 1.28 1. You had two other options: the arts stream (A) or the commerce stream (C).21 1. but not inside. you would have expected a career. Define opportunity cost and explain it with the help of an example. How will it affect the country’s PPC? Distinguish between microeconomics and macroeconomics.29 Give two examples of under-utilisation of resources. 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 . 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. What is your opportunity cost of choosing the science stream? (Note: It is only a hypothetical example.26 1. If you would have chosen (A). you would have expected a career. “An economy always produces on. Its production possibilities are shown in the following table.” Defend or refute. Which factors lead to a shift of the PPC? Give two examples of growth of resources. offering you Rs.30 A country produces two goods: green chilli and sugar.27 1. 4 lakhs annually. If you would have chosen (B). Suppose that you choose the science stream.23 1. giving you Rs.14 INTRODUCTORY MICROECONOMICS 1.20 1. a PPC.

I I CONSUMER BEHAVIOUR DEMAND AND .U N I T.

and various automobile components in a Maruti car workshop. . “how” and “for whom” are solved through forces of demand and supply for various goods and services. wheat in a flour mill. households are the demanders of alu bhujia and companies like Bikanerwala and Leher are the suppliers.e. households are the 1 2.1 As consumers.1 Consumer's Equilibrium 2. In summary. This service is demanded by companies or firms.g. in a marketoriented economy. Another example is the service of a computer programmer. As opposed to final goods and services. the central problems of “what”.2 Meaning and Determinants of Demand 2. In case of services that are required for production. households demand them and firms supply them. Who are the suppliers of this service? The households. a bicycle repair job etc. there are “intermediate” goods (or raw materials) that are “consumed” (i. a haircut. because some members of some households work as computer programmers.3 Market Demand Curve 2. The examples are steel in a bicycle factory.4 Price Elasticity of Demand Final goods and services include things that are consumed by households. Who demands a particular good and who supplies it? This depends on the type of good or service in question. used up) by businesses. e. Consider a final product such as alu bhujia. in case of final goods and services. a piece of bread.16 INTRODUCTORY MICROECONOMICS CHAPTER 2 CONSUMER CHOICE AND THE DEMAND CURVE • • • • In Chapter 1 it was stated that.

and so on. served with tamarind (imli) – water and fillings. Thus the marginal utility from consuming one gol guppa is 20 and that from consuming two gol guppas is 22. . defined as the total psychological satisfaction a consumer obtains from consuming a given amount of a particular good. and focus on the question of how much of any particular good a consumer should demand (or buy) at a given point of time. she would not demand it at all.1 Utility Concepts We begin with the notion that a consumer derives some satisfaction from consuming a product. the total utility from consuming two gol guppas is 20+ 22 = 42 utils.the mouth-watering small round-shaped puffed puris. the teachers can use other popular eatable as example to explain the concept. the marginal utility and the total utility obtained from consuming three gol guppas are 18 and 42 +18 = 60 utils respectively. 2. Then. such decline in the intensity of desire starts with the third gol guppa you consume. defined as the utility from the last unit consumed. Consider for example your consumption of gol guppa . It states that. 14 utils. Let this (psychological) 1 unit be called “utils. You can now notice the relationship that total utility is the sum of marginal utilities. there is another important concept called marginal utility.” Thus. Getting on with our story. This pattern of marginal utility is called the law of diminishing marginal utility.1 Imagine that you are hungry and have come to your favourite gol guppa vendor. How should a consumer decide how much of a product to buy? What factors do affect this decision and how? 2. In order to understand this. we first have to learn a few concepts. This is captured by a term called total utility. 18 utils. say. In the same manner we can calculate total utility from consuming three. regardless of how much you like gol guppa. otherwise. in your case. say. let the third unit give you utility equal to a number less than 22. Accordingly.1 CONSUMER’S EQUILIBRIUM: THE BASIS OF THE LAW OF DEMAND Let us ignore for the moment the word “equilibrium” or the phrase “Law of Demand”.1. Suppose that if you consume only one gol guppa you derive 20 units of pleasure or utility measured in some units. This chapter deals with households as consumers and their demand for final goods and services. Besides total utility. the total utility from consuming one gol guppa is 20 utils. The next (fourth) unit gives you still less utility. your intensity of desire for gol guppa must fall. Let the second unit give an additional utility of 22 utils. four or five units and so on.CONSUMER CHOICE AND THE DEMAND CURVE 17 suppliers and the fir ms are the demanders. Suppose that. Suppose that you like gol guppa so much that eating just one increases your appetite for it. after consuming a certain amount of a good Incase gol guppa is not known to the children. That is. after consuming a certain amount.

2 How many Gol Guppas will you consume or buy? From Table 2. each additional one can only give you more negative utility.18 INTRODUCTORY MICROECONOMICS or service. If you think about it.) Table 2. and you are very full in your stomach – suppose that the next (9th) unit gives zero utility. Suppose that eating the 10th unit makes you vomit! This is obviously not a pleasant experience and should give you negative satisfaction. (If you are crazy and still eat more. you will eat less than 10 gol guppas. it is clear that if you are a rational (not crazy) consumer.1 Units Consumed of Gol guppa 0 1 2 3 4 5 6 7 8 9 10 with the 10th unit be -7 utils.1.1. That is. let the utility associated Table 2. the marginal utility of ten gol guppas is -7 utils. When you have already consumed quite a few gol guppas – say 8. Let us resume our story once again. this law is very natural and should hold for any product one consumes.1 summarises your experience with gol guppa in terms of marginal utility and total utility up to 10 units of consumption. Accordingly. 2. Imagine what will happen if you keep gulping more. Columns (2) and (3) present the marginal and total utility schedules. 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 . In fact it is considered as a fundamental psychological law. since consuming 10 or more gives you negative marginal utility. You will see the critical role of it a little later. the marginal utility from it diminishes as more and more is consumed.

i. For example. Because. Similarly. chocolate etc.. Suppose that. we can determine how many gol guppas you will consume. and. We keep on making such comparisons for successive units. it is 4 utils and let the price of gol guppa be Rs. 2 for it. Hence we have found the answer to our query: you will buy 5 or 6 gol guppas. 2. 11.1).2 illustrates this.CONSUMER CHOICE AND THE DEMAND CURVE 19 were free. 22/4 = Rs. how much a rupee is worth to you in terms of other goods. you pay – and thus sacrifice – Rs. Having gone through the example. What happens with the 6 th gol guppa is a bit different. this is like the net gain to a consumer.. you would have consumed 8 or 9 units at which your total utility is at its maximum. at either of these two levels of consumption. We see that this difference is maximised (equal to Rs. 2. whether or not you buy the 6th unit does not make any difference. from the second unit. which is equal to the price. the marginal utility in terms of rupees is less than the price (you can check this directly). ice cream. The above comparisons between how much of marginal utility in terms of money you get and the price you pay implies that. Consider first whether you will buy just one gol guppa. its price were zero.e. From consuming only one. The last column gives the difference between these two columns. the 5th gol guppa is worth having it since it gives Rs. you may not wish to consume so many. On the other hand.50. But as long as you pay something for it. You would like to know how much utility you could have obtained if you had spent some amount on other items. Since the marginal utility of a rupee is 4 utils. It gives you utility worth Rs. 2 per piece. it is clear that you will not buy (consume) more than 6.g. 5. However. 2. 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 2.25) when your gol guppa consumption is either 5 or 6. exactly how many gol guppas you will eat would depend not only on marginal and total utility from consuming gol guppas. 5. 11/4 = Rs. you get utility worth Rs. defined as total utility divided by the marginal utility of one rupee (equal to 4 utils in this example).75 worth of utility. Will you buy it? The answer is that you will be “indifferent. 8/4 = Rs. while you pay only Rs. In other words.” that is. but also on the price of gol guppas. from consuming one gol guppa. we can now understand why this . for you. Its second column gives total utility in terms of money. Hence you will buy the second gol guppa also. you obtain utility equal to 20 utils (from Table 2. you get utility worth Rs. we can say that. 20/4 = Rs. We now define marginal utility of one rupee as the extra utility when an additional rupee is spent on other available goods in general. Having the information on price and marginal utility of a rupee. at any level of consumption beyond 6. Hence you will buy the first unit. Column (3) gives your total expenditure or spending on gol guppas. which is greater than the price. e.

as economists say. attain consumer’s equilibrium – at 5 or 6 gol guppas.75 23 Total Expenditure (Rs. This is indeed the principle and we can state this in two alternative ways. frequently used in economics.25 24.) 0 2 4 6 8 10 12 14 16 18 20 Difference (Rs. the marginal utility in terms of money (Rs. stop – or.” The word “equilibrium”.50 9 10.75 6. we can then say that consumer’s 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. means a position of rest. That is.) 0 5 10.50 11. .3 The General Principle From the example just worked out.50 15 18. we can now derive the general principle of consumer’s equilibrium with respect to any particular good.2 Difference between Total Utility in Terms of Money and Total Expenditure Total Utility in terms of money (Rs.) 0 3 6.75 3 Amount Consumed of gol guppas 0 1 2 3 4 5 6 7 8 9 10 section is titled “Consumer’s Equilibrium.1.25 10. note that. 2) is equal to price (Rs. In general.25 24.50 21. 2).25 8. you will rest.25 11. at this level of consumption. Because you do not want to consume less or more than these quantities. Recall that one of our answers is 6 gol guppas. 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. In this example.75 24. 2.20 INTRODUCTORY MICROECONOMICS Table 2. Ignoring the other answer for the moment.25 23.

The only modification is that. If. different amounts can be bought even when the prices of goods and services she consumes remain unchanged. then a change in the price of tea should affect her consumption of coffee and vice versa. a consumer buys many goods. with condition (A) [or (B)] met. for example by weight on a weighing scale. .g.2 2.CONSUMER CHOICE AND THE DEMAND CURVE 21 In particular. and. this is loosely stated as “marginal utility is equal to price. This is quite natural. They are namely. a product is perfectly divisible and thus can be measured continuously. The consumer’s equilibrium analysis with respect to many goods (which is outside our scope) suggests two other factors. gol guppa). prices of related goods and income. This possibility exists because gol guppas are not perfectly divisible: they cannot be measured continuously like points on a straight line. the condition (A) or (B) holds either exactly or approximately. We do implicitly assume from now on that a product is perfectly divisible and thus treat (A) or (B) as the condition of consumer’s equilibrium. for example. while our preceding analysis is confined to one good (e. Sometimes. If a person consumes. tea and coffee. The last three factors just mentioned are called the determinants of demand. it will change the marginal utilities from a product.” Now go back to the example once again and see that the consumer’s equilibrium is also attained at 5 gol guppas.2 MEANING AND DETERMINANTS OF DEMAND Our analysis of consumer’s 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. in reality. there will be just one level of consumption at which the consumer’s equilibrium is achieved. the condition (A) says that the marginal utility of a product in terms of money be equal to its price. namely. the price of a product is not the only factor that influences how much a consumer should buy of that product. the ratio of marginal utility to price changes so that the consumer’s equilibrium will occur at a different level of consumption. the consumer’s equilibrium condition will be fulfilled at some other level of consumption even when there is no change in price. 2 Nothing essential or important is gained by deviating from this assumption. Moreover. when a good is not perfectly divisible. 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. if income changes. if there is a taste change. It is because. Also. where the principle is not satisfied. For example. as the product price changes. instead.

while the right column lists the corresponding quantities demanded. Consider an essential product. . for a particular family.3 Own Price (in Rs. Moreover. 2. edible oil or sugar. (b) and (c). as the own price of a commodity increases. (b) income and (c) tastes. It is because an increase in the own price lowers the Table 2. there may be other determinants of demand for a good. Suppose that. It states that other things remaining unchanged. within a month. We see that the demand curve is downward sloping.1 Own Price: The Law of Demand To isolate its effect.g.) 12 13 14 15 16 17 A Demand Schedule Quantity Demanded of Apples 24 17 12 9 7 6 quantity demanded. 3 The law of demand in tabular form is called a demand schedule. income or tastes do not change. The demand curve corresponding to the demand schedule in Table 2. future price expectation. as Apart from (a). 2. taste changes can occur not only because of natural changes in a person’s liking. income and tastes. It is assumed that the prices of related goods. you would buy more of these commodities now (and store them) even if prices. say. family income and tastes are kept fixed at some pre-determined levels. You would then anticipate that supply interruptions would occur and prices of these commodities would skyrocket. Each point of the demand curve shows the quantity demanded that is consistent with consumer’s equilibrium. Table 2. 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.1. The answer is summarised as what is called the Law of Demand. which are consistent with its consumer’s equilibrium. Why is the Demand Curve Downward Sloping? Isn’t it obvious that the demand curve is downward sloping? That is. the quantity demanded of it by a consumer falls. hold the other factors constant and ask how the quantity demanded of a product changes as its own price changes. The left column lists various prices. If you are a rational consumer.3 lists its quantities demanded of apples at different prices. Suppose there is a weather prediction that your village or town will be hit by a severe cyclone in the next three days.3 is shown in fig.2. It typically measures own price along the y-axis and quantity demanded on the x-axis. “Other things” refer to the prices of related goods. we obtain a demand curve.22 INTRODUCTORY MICROECONOMICS (a) prices of related goods. but also due to advertising of products.. e. If we graph a demand schedule.

65. This can 4 be restated as follows. The consumer’s equilibrium condition now holds at 3 T-shirts consumed.4. The quantity demanded of T-shirts is 7 when the price is Rs.” To begin with. that is. 65. Then. Likewise.CONSUMER CHOICE AND THE DEMAND CURVE 23 Table 2. This can be turned around to say that if the price of a product falls. suppose that the price of T -shirts increases to Rs. it is not. This means that the marginal utility curve itself is the demand curve. the demand curve is downward sloping because of the law of diminishing marginal utility. 2. There is a reason behind it. for simplicity. the law of diminishing marginal utility. 7) will be on the demand curve. suppose that the price of a T -shirt is Rs. 45. our consumer’s equilibrium condition (A) can be stated as “Marginal Utility = Price. that the marginal utility of a rupee is equal to 1 util. Hence the pair (65.3 Marginal Utility of T-shirts 75 70 65 60 55 50 45 4 5 6 7 the own price increases. her marginal utility decreases and therefore she is willing to pay less per unit. Interestingly.4 Consider Table 2. the demand curve is essentially the marginal utility curve. and. 3) will be on the demand curve too. Similarly. The consumer’s equilibrium condition holds at 7 T-shirts consumed.4 Marginal Utility Schedule and the Demand Schedule Quantity of T-shirts 1 2 3 Fig. we can determine that all other points on the marginal utility schedule are points on the demand schedule. An intuitive way to see this is that. a consumer buys more of it. as a consumer buys more of a good. . Indeed. which lists the marginal utility from consuming T-shirts. again for simplicity of exposition. the quantity demanded of a product falls. 45. diminishing marginal utility sets in with the very first unit of consumption.1 Demand Curve Corresponding to Table 2. the quantity demanded is 3. Thus the pair (45. Assume further. namely. at price Rs. Mark that.

who lives next door to you.5 in consumption. If the price of petrol rises. How will this affect Mrs. Sugar is complementary to tea Table 2. Das’s demand for gulab jamun? It will increase. 200 20 11 5 2 1 Quantity Demanded of Tea when Price of Coffee (per kg) = Rs. 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. 250. 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. the quantity demanded of tea is 18. the quantity demanded of tea increases for any given price of tea. Numerical examples of cross price effects are given in Tables 2. In other words. Why. given price of coffee = Rs. at the same tea price (Rs. On the other hand. 5 a piece to Rs. or.5. the quantity demanded of tea should fall. 150 170 190 210 230 .6.2 Determinants of Demand Now turn to the remaining factors that affect the quantity demanded of a particular product. note that as the price of coffee rises from Rs. the quantity demanded of tea is 11. given coffee price = Rs. The same should happen to the demand for tea if the price of coffee rises or vice versa. Change in Price of a Related Good Suppose that Mrs. Another example of a pair of complementary products is petrol and cars. at tea price equal to Rs. consider tea and sugar. because burfi and gulab jamun are substitutes of each other in consumption. Das. whereas. because tea and coffee are also substitutes. Suppose that burfis become more expensive: from Rs. 250. 170). 250 28 18 10 7 4 Price of Tea (per kg) Rs. For example. Consider another example: that of tea and coffee. what we have called the determinants of demand.2. 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. Thus. These examples illustrate cross price effects: how the demand for one particular product is affected by a change in the price of another. Burfi and gulab jamun are her favourites. if the price of tea goes up. the quantity demanded of cars should fall. 200 to Rs. 170. In Table 2. has a weakness for sweets. 8 a piece. 200. which will reduce the demand for sugar.5 and 2.24 INTRODUCTORY MICROECONOMICS 2.

Hence. we can say that. notice that. not because your taste changes but because you can afford more 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. generally. the quantity demanded of sugar decreases for any given price of sugar.2 Change in demand due to increase in the price of a substitute good they are cheap. We see that demand curve for tea when the price of coffee is Rs. in Table 2. 170 20 14 9 6 5 Quantity Demanded of Sugar when Price of Tea (per kg)= Rs. Will you buy more of ice cream. Hence.6.CONSUMER CHOICE AND THE DEMAND CURVE 25 Table 2.3 graphs Table 2. an increase (a decrease) in the price of a substitute good shifts the demand curve for a product to the right (left). Suppose that your pocket money increases. an increase (a decrease) in the price of a complementary good shifts the demand curve for a product to the left (right). Figure 2. You like peanuts much less. Ice cream is your favourite but it is costly. The demand curve for sugar when tea price is Rs.6. 200 12 7 4 2 1 Price of Sugar (per kg) Rs. as the tea price increases from Rs. 2.2. Very likely. you will buy less of peanuts.5 are graphed in Figure 2. but Fig. Thus. which is your favourite. as income increases. 170 to Rs.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. Similarly. a consumer may . 5 8 11 14 17 tea given in column (2) and (3) of Table 2. 200. A Change in Income Suppose that you only buy peanuts and ice cream from your pocket money. 200 lies to the left of that when the sugar price is Rs. 200. 250 lies to the right of that when the price of coffee is Rs. 170.

the demand curves are indicated by FF 0 (original) and FF 1 (new) in Fig. nor mal goods are those. The new demand curve. then we say that it is an inferior good. 2. 300 Rs.g.7 presents numerical examples of both normal and inferior goods. at any given price. is indicated by the line NN0 in fig. 400 15 12 9 7 5 3 19 16 13 11 9 7 1 2 3 4 5 6 . These are graphed in figs. 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. is marked by NN 1 that represents the column pair (1)-(3). If she buys less (e.5. ice cream).26 INTRODUCTORY MICROECONOMICS buy more or less of a product. Table 2. Observe that. for which demand falls as income rises.g. Put differently. then we say that the product in question is a normal those. when income of Rs. If she buys more (e. The original demand curve for the normal good. 300 Rs. For the inferior good. 300. peanuts). when income is Rs. This represents the column pair (1)-(2).7 Own Price Normal and Inferior Goods An Inferior Good Own Price Quantity Quantity Demanded: Demanded: Income = Income = Rs. as income increases. 400. Inferior goods are Table 2.3 Change in demand due to increase in the price of a complementary good good. quantity demanded of the normal good increases (by comparing columns (2)-(3)) and that of the inferior good decreases (by comparing columns (5)-(6)).4. 2.4 and 2. Hence an increase in income shifts the demand curve to the right if the good is nor mal. 2. for which demand increases as income increases.

This will shift your demand curve for Coca Cola to the right. A graphical representation of this is the demand curve. We can then say Fig. jowar etc. Fig. less (more) is the quantity demanded.5. income and tastes. 2. and. you have to consume more of a product although you don’t like it. in which your favourite actor drinks Coca Cola. bajra. maize and related cereals. for instance. A Change in Tastes Finally. Within this category. consider a taste change. the inferior-good characteristic applies to bajra.) constitute an inferior good. In India. this is also considered a taste change.CONSUMER CHOICE AND THE DEMAND CURVE 27 fig. A taste change may result from a change in a person’s liking. 2. there are much fewer examples of inferior goods than normal goods. wheat.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. from some other source.2. A change in the own price causes a movement along a given demand curve: higher (lower) the price. This is an example of a “favourable” change in tastes. The law of demand refers to the effect of a change in the own price. Suppose you are impressed by an advertisement in TV. An unfavourable change in taste will imply the opposite.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). If. as a result. 2. which is downward sloping. jowar. or.4 Change in demand due to increase in income (Normal Good) . In the real world. your liking for Coca Cola increases. 2. Yet there are important examples. for health reasons. cereals as a single category of goods (that includes rice. Thus an increase in income shifts the demand curve to the left if the good is inferior.

6 Change in Quantity Demanded Versus Change in Demand (3. fig. Amar demands 5. meaning a shift of a demand curve from DD0 to DD1 due to a change in the prices of related goods. Akbar 6 and Anthony 8 per week.6(b) shows a change in demand. It is obtained by summing up the demand curves across consumers or households. Consider the market for. say. income or tastes. Individual demand schedules are given by column pairs (1)-(2). There is a price change from P0 to P1. A numerical example is given in Table 2. How do we get the demand curve of a product by all individuals together in an economy. 19) is a point on the market demand curve. there is a movement along the same demand curve from A to B. As a result. Suppose that there are three consumers in the market: Amar.g. we call this a change in demand. 2. Akbar and Anthony. If at the price equal to Rs. In contrast. 2. The column . gulab jamun. (1)-(3) and (1)-(4).6(a) illustrates a change in the quantity demanded. the economy of a region or a country? The economy-wide demand curve for a particular product is called the market demand curve. Plot the points. Hence (a) Change in Quantity Demanded (b) Change in Demand Fig.. 2. 2. In contrast. when a change in any other factor causes a (left or rightward) shift of a demand curve. join them and you get the market demand curve. The distinction between the two concepts is illustrated in fig.8. e. 3 a piece.6. Repeat the same exercise for other possible prices and obtain the corresponding points. 2.3 MARKET DEMAND CURVE We have studied consumer’s equilibrium and the determinants of demand for a good from the perspective of a single individual. Fig. The quantity demanded changes from Q0 to Q1.28 INTRODUCTORY MICROECONOMICS Such a movement is called a change in the quantity demanded. then the total quantity demanded is 19.

. that is. 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. The right most line is the market demand curve.7. the market size.5 2. The concept of elasticity captures the magnitude of change or the degree of responsiveness. the distribution of income. which refer to the huge number of consumers in these countries. Individual and Market Demand Schedules for Gulab Jamun Amar’s Demand 7 6 5 4 3 2 Akbar’s Demand 15 10 6 3 1 0 Anthony’s 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. (3) and (4). This is obtained by horizontally summing the individual demand curves. 2. or what we can call. the price elasticity of demand quantifies the effect of a change in own price on the quantity demanded. Akbar’s and Anthony’s demand curves are respectively marked by their names. (c) consumers’ tastes (d) the number of consumers who buy the product.CONSUMER CHOICE AND THE DEMAND CURVE 29 pair (1)-(5) gives the market demand schedule. income or other factors change. Note that for each row (price).4 PRICE ELASTICITY DEMAND OF We have seen how various factors like own price and income affect the demand for a commodity. or Table 2. (b) income levels across individuals. For example. The direction of change was our focus . Amar’s. (a) prices of related goods. the entry in column (5) is the sum of corresponding entries in columns (2).whether the quantity demanded increases or decreases as price. These individual demand schedules and the market demand schedule are graphed in fig.8 what we can call. because of their market sizes.

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. let the original price be P0 and the original quantity be Q0. ∆P / P0 Consider the following numerical example. (P1 − P0 ) / P0 If we further denote a change in quantity as ∆Q and a change in price as ∆P.1 Definition and Formulas Formally.4. Thus (C) can be written as (D ) e D = − (Q1 − Q0 ) / Q0 . 2. Then the % changes in price and quantity demanded are respectively equal to [(P1–P0)/P0]×100 and [(Q1–Q0)/Q0]×100. Some other textbooks define the price elasticity the same way as above. Suppose that in your home town. rasgoolas were being available at Rs. referred to as “elasticity”. Along a given demand curve. Strictly speaking. except for the “minus” sign. Hence attaching a negative sign in front of the ratio makes the sign of eD positive. which is. our definition gives the absolute value of the elasticity.00 per piece and the residents of . we can also write (E ) eD = − ∆Q/Q0 . Suppose that the price increases to P 1 and the quantity demanded falls to Q1. the ratio of % change in quantity demanded and that in the own price is negative in sign.30 INTRODUCTORY MICROECONOMICS Fig. But there is no reason to get confused. often.7 Individual and Market Demand Curves 2. 5.

at their point of intersection. If eD<1. Now they become more expensive for some reason. P0 is the price of the product. Therefore.g. The demand curves DD and DD´ intersect at the point C. Why? Because the original quantity demanded is the same. is equal to 20/10 = 2. it is said that the demand is unitarily elastic. What is the price elasticity of demand? We have to do some arithmetic. Suppose that the people in the town are now buying 960 rasgoolas per day. price elasticity associated with DD´ is higher. The % change in quantity is equal to [(960 – 1200)/1200] ×100 = – 20. 2. If two demand curves intersect. the price elasticity. then the % change in quantity demanded must exceed the % change in price. the demand curve takes a particular Fig. A very desirable property of the elasticity formula in measuring the degree of responsiveness is that it is independent of the choice of units. Properties 1. the elasticity associated with the flatter demand curve is higher.CONSUMER CHOICE AND THE DEMAND CURVE 31 the town were buying 1200 rasgoolas per day. the demand for luxury goods is elastic and that for necessary goods (e. This is exhibited in fig.8. while the % change in price is the same along both demand curves. we say that the product demand is inelastic. It is because any percentage change of a variable is independent of units. the elasticity is greater along the flatter demand curve DD´. the % change in quantity demanded is less than that of the price. 3. equal to D0. In particular.8 Elasticity Comparison .g. basic food items) is inelastic. and. The % change in the price is equal to [(5. Finally. Higher the value of the price elasticity. We then say that the product demand is elastic (e. 2. if eD>1. and. are eating less. the % change in quantity demanded is greater along DD´. greater is the degree of responsiveness of quantity demanded to price. Hence. 5. The claim is that.50 – 5. In this special case.00] ×100 =10. at Rs.50 per piece. eD. the quantity demanded falls more along the flatter demand curve (by amount D2D0 as compared to D1D0 along DD). say to P1. jewellery). This implies that. along both demand curves. Typically. At this point. if eD =1. Fewer people are eating rasgoolas and many who eat. 2. if there is an increase in price. at price P0.00)/5.

like demand for a rare medicine or some very bad case of addiction to undesirable products like opium. its price elasticity of demand is likely to be high.e. This is evident..9 Unitarily Elastic Demand elasticity is equal to infinity. Fig.10 Elasticitiy = 0. (b) Perfectly Elastic Demand Fig. 4. 2.10(a). along a vertical demand curve.10(b) shows this.2 Factors Affecting the Magnitude of Price Elasticity In general. This case is exhibited in fig. 2. the demand curve is vertical. If the product is absolutely essential.32 INTRODUCTORY MICROECONOMICS shape.9 exhibits this. because even a very small increase in price will make consumers switch to other (a) Perfectly Inelastic Demand Fig. 2. ∞ . the quantity demanded is totally insensitive to any change in price. It is a curve.. Fig. Availability of Close Substitutes: If close substitutes of a product are readily available. 2. the price elasticity is zero. In this case. the price 2. i. The last special case is the one. the product demand is totally or perfectly inelastic. because. 2. the magnitude of price elasticity depends on the following factors.4. An economic example of this demand curve will be given in Chapter 4. There are two other special cases. where demand curve is horizontal and thus the demand is perfectly elastic. i. called rectangular hyperbola in geometry.e. which extends towards the x-axis and y-axis in a uniform manner without touching them.

The demand for oil is more elastic today than it was 30 years ago. for an opium addict. In particular. whereas for other casual opium takers. 2. In the 1970s. It is indispensable. “luxury” items like eating in a restaurant. substitutes of oil could not be available and the demand for oil was very inelastic. the whole world was shocked. buying a big-size colour TV etc. A form of consumption such as eating out in fivestar restaurants is a luxury for many people. rice in Orissa or West Bengal. that is. their demand for it is very elastic. it may be an essential demand. Hence the demand for these items is likely to be relatively elastic. if it is a staple food item of a particular region. Hence his demand for five- star restaurant food is inelastic. Habits: Some products which are not essential for some individuals are essential for others. Time Period: All other things remaining the same. because he is already habituated. substitutes became more readily available. For example. a graphical formula or a geometric method can also be used to measure elasticity. Clip 2-1 reports price elasticities for various products that have been estimated by various authors. Otherwise. On the other hand. if it is a high-price item and takes a major portion of your total expenditure. when the price change is very small. when OPEC (Organisation of Petroleum Exporting Countries) dramatically increased the price of oil for the first time in history. the demand for essential products is likely to be inelastic. Countries could not immediately find and adopt any other forms of energy for their needs. the elasticity is likely to be small.3 Measurement of Elasticity Finding price elasticity of demand using its definition as such is called the percentage method of measuring elasticity. Hence the demand for rice is likely to be inelastic. then the price elasticity is likely to be small.4. as shown in fig.CONSUMER CHOICE AND THE DEMAND CURVE 33 products in a big way. More generally. and. In other words. the demand is likely to be elastic. are relatively dispensable. say. But. for someone who is very rich. therefore. there are no (very) close substitutes available. Suppose that it is a straight-line demand curve.11. your demand for it is more sensitive to a price change. On the other hand. more elastic is the demand for any product. the longer the time period. 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. the demand for opium is very inelastic. The demand for salt is an example. having intercepts A and B respectively on the price axis and quantity axis . the elasticity of demand is likely to be high. But over years alternative types of energy were developed. The consumption of petrol is a prime example. in the absence of close substitutes. 2. by definition. Similarly.

. J.S. 11. and R. as these are essential items. Cereals & cereal substitutes (India) Other foods (India) Clothing (India) Long distance phone calls from Public Call Offices (India) Residential Land in Philadelphia (U. As you see.580 5. The elasticity for this item is also less than one. and Ranjan Ray. It indicates that long-distance telephone calls are not a “luxury” demand anymore. 11. 3. Voith. the price elasticities for food items and clothing are less than one. pages 177-194. and P.” Journal of International Development. P.V. 0. they have become a necessity in a country like India. Five examples are reported below.34 INTRODUCTORY MICROECONOMICS Clip 2-1 Price Elasticity Estimates Price elasticities have been estimated for various products and services and in the context of different countries.” Information Economics and Policy.A. 4. “The Price Elasticity of Demand for Residential Land: Estimation and Some Implications for Urban Reform. 2001. 4 is an example of a service: long distance phone calls from PCOs. 1.64. Wharton School of Management.” mimeo. The item no.804 0.640 Gyourko and Voith (2001) Das. “Demand for Telephone Usage in India. Product/Service 1. V. 5 shows that the demand for residential land in America is elastic. Srinivasan. Note that item No. four of which are for India and one for America. 1999. pages 47-74.544 Source Meenakshi and Ray (1999) Meenakshi and Ray (1999) Meenakshi and Ray (1999) Das and Srinivasan (1999) 2.560 0. J. “Regional Differences in India’s Food Expenditure Pattern: A Complete Demand Systems Approach. Gyourko. Meenakshi. 1999.) Price Elasticity Estimate 0. equal to 1.

P and Q were respectively Rs. Let us now calculate TE. At point B the elasticity is zero and at point A it is infinity. In other words. Then.200. and. Because of the increase in the price of Fig. hence TE was equal to Rs.8 2. Originally. You will find a treatment of this in a higher-level micro economics textbook.50 and quantity = 960. 5. price by P and quantity by Q. the total expenditure on a particular good = price × quantity. Thus the total expenditure has fallen.7. . Suppose that initially the price is P0. TE = Rs. the consumer is at point C on the demand curve. A proof of it is given in Appendix 2. 2. as there is a change in price. 5. then TE = PQ.00 and 1. Return to the rasgoola example and ask the following simple question. 6. the price elasticity turns out to be equal to BC/AC. at a certain point along a straight-line demand curve. the demand for rasgoola is elastic.4. It may not hold when the demand curve is not a straight line. If it is not a straight-line demand curve. That is. the total expenditure falls. The point elasticity formula implies that. This graphical formula is called point elasticity. then the point elasticity measure at a point on it is based on the tangent to the curve at that point.280. and the quantity consumed is Q0. 5.11 Point Elasticity along a Straight Line Demand Curve rasgoolas. as price increases. Note also that the elasticity is equal to 2. does consumer spending or total expenditure on rasgoolas increase or decrease? By definition.2 Total Expenditure and Price Elasticity The concept of price elasticity does not just quantify the relationship between price and quantity demanded.6. 6 7 8 This is not a general property of price elasticity. is equal to the lower segment divided by the upper segment of the demand curve at that point. At the new price Rs. If we denote total expenditure by TE.CONSUMER CHOICE AND THE DEMAND CURVE 35 respectively.000. in the example. as there is a price increase. for small price changes. it also indicates the direction in which the total expenditure on a product changes. point elasticity. 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. that is.

36 INTRODUCTORY MICROECONOMICS It turns out that such opposite movements in the directions of price and total expenditure changes hold. but always.9 scope. In this case a large price change leads only to a relatively small adjustment in quantity. If the demand for a product is elastic. 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 . Hence the total expenditure must change in the same direction in which the quantity changes. Now you see that. However. Hence the total expenditure must change in the same direction as the price change. not just in this example. the total expenditures at all points on that demand curve are the same. the total expenditure always increases as price increases. Similarly. an increase in price leads respectively to a decrease. unitarily elastic or inelastic. as a special case. Just the opposite holds when the product demand is inelastic. i. but it is beyond our Table 2. then the total expenditure does not change with any price change. it means that a small price change invites a relatively large adjustment in the quantity. This result can be proven algebraically. So far we have discussed how we can determine the direction of change in total expenditure. depending on the magnitude of price elasticity. given the direction of change in the price and given whether the product is elastic or inelastic. Alternatively. a price increase leads to an increase in total expenditure. if we know the direction of change in price and the direction of change in total expenditure..9 presents this result in a tabular form. Moreover. If the product demand is elastic. Table 2. if the product demand is unitarily elastic.9. 2. it is quite intuitive. quantity falls and the fall in quantity is associated with a fall in the total expenditure. which depicts the unitarily-elastic case.e. There is thus a general relationship between the direction of price change and the direction of change in total expenditure. no change or an increase in the total expenditure on the product. That is. as price increases. if the product demand is inelastic. when the product demand is elastic. You can relate the last case to fig. we can infer whether the product demand is elastic or inelastic.

via price elasticity. . the difference between total utility in terms of money and the total expenditure on a good is maximised. while an increase in the price of a complementary good causes a decrease in demand or a leftward shift of the demand curve. which is downward sloping.e. the total value of sales is usually called total revenue and note that total revenue is equal to the total expenditure by the consumers. 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.. between changes in price and total expenditure has important practical implications. The demand curve is essentially same as the downward sloping portion of the marginal utility curve. Consumer’s equilibrium is attained when the condition that the marginal utility in terms of money is equal to the price is met. An increase in the price of a substitute good causes an increase in demand or a rightward shift of the demand curve. l 9 We will see the use of the term “total revenue” in Chapters 4. if because of a price increase.9 Hence the relationships between elasticity.CONSUMER CHOICE AND THE DEMAND CURVE 37 instance. the demand curve shifts to the right or left. If you are the halwai shop owner and are thinking about increasing the price of rasgoola. You can readily verify that from Table 2. At the consumer’s equilibrium.9. Return once again to the rasgoola example. The demand curve is downward sloping because of the law of diminishing marginal utility. 6 and 7. price change and total expenditure are important from the viewpoint of decision making by a producer or a firm. who sells rasgoolas. then the product demand must be inelastic. As income increases. i. Suppose that there is only one (giant) halwai shop in town. The law of demand defines demand curve. 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. wouldn’t you want to know if a price increase would increase or decrease your total sales in rupees? From a seller’s perspective. This link. the demand for a product increases or decreases. the total expenditure increases. depending on whether the good is normal or inferior.

Greater the availability of close substitutes of a product. In case of a unitarily elastic demand. If demand is elastic (inelastic). Longer the time horizon.1 2. Greater is the share of the total budget spent on a particular good. .38 INTRODUCTORY MICROECONOMICS l A favourable taste change increases the demand for a good.e. When two demand curves intersect. a change in price leaves the total expenditure on the product unchanged. Define marginal utility. the demand for luxury products is elastic and that for necessary goods is inelastic. Typically. the price elasticity is zero (infinity). an increase in the price of the product leads to a decrease (an increase) in the total expenditure on the product. the higher is the price elasticity of demand for a product. distribution of income.2 Define total utility. Given that the demand is a straight line. an unfavourable change does the opposite. the point elasticity is equal to the lower segment divided by upper segment of the demand curve at that point. the elasticity associated with the flatter demand curve is greater.. i. tastes and the market size. Market demand curve is obtained by horizontally summing up the individual demand curves. the demand curve is a rectangular hyperbola. The price elasticity of demand is independent of the choice of units. If the demand curve is vertical (horizontal). the more elastic is the demand for it. shifts the demand curve to the right. The determinants of market demand curve are prices of related goods. the more elastic is the demand for a product. l l l l l l l l l l l l EXERCISES Section I 2. In case of elasticity equal to one.

) .14 How is total utility derived from marginal utilities? State the law of diminishing marginal utility. Name two determinants of the demand.10 2. If the price of good X rises and it leads to an increase in demand for good Y.12 2. how are the two goods related? Define price elasticity of demand. (Assume that the total utility of consuming zero is zero. Derive her total utility schedule. Give the meaning of demand.16 Total Utility 0 10 25 38 48 55 A person’s marginal utility schedule is given below. Amount Consumed 0 1 2 3 4 5 2.6 2. Give an example of a pair of commodities such that one of them is complementary in consumption to the other.9 2.8 2.4 2.15 A person’s total utility schedule is given below. List the factors that cause changes in demand.3 2.11 2.7 2. Section II 2. how are the two goods related? If the price of good X rises and this leads to a decrease in demand for good Y. 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. Derive her marginal utility schedule.13 2.CONSUMER CHOICE AND THE DEMAND CURVE 39 2.5 2.

Her marginal utility from eating 3 ice creams is 90. Should she eat more ice cream or should she stop? Explain the determinants of demand.19 Marginal Utility 7 10 8 6 3 0 2.18 2.31 What is consumer’s equilibrium. who loves ice cream. has already eaten 3.28 2.26 2.21 2. 30. 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. suppose that the marginal utility of a rupee increases. Lakhmi.27 2. Starting from an initial situation of consumer’s equilibrium.22 2.25 2. State the condition of consumer’s equilibrium. the marginal utility of one rupee is 3. 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. Suppose further that. Will it increase or decrease the quantity demanded of the product? Ice creams sell for Rs. How does an increase in income affect the demand curve for a normal good? .20 2.30 2. What is meant by cross price effects? Give two numerical examples to illustrate this.24 2.29 2. 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.23 2.40 INTRODUCTORY MICROECONOMICS Amount Consumed 1 2 3 4 5 6 2. 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. for her.17 2.

37 2. Originally. 10 and the quantity demanded was 1000 units.33 2. (c) inferior good and (d) normal good. medicine. Distinguish between a change in quantity demanded and a change in demand.41 Explain the determinants of the market demand curve. Draw diagrams showing elasticity equal to (a) zero.39 2.32 2. Derive the market demand curve. Distinguish between individual and market demand curves. a particular brand of lipstick. Calculate the price elasticity. The product price changes to Rs.35 2.40 2. They are Isha.CONSUMER CHOICE AND THE DEMAND CURVE 41 2.) Demanded by Isha 1 2 3 4 5 6 16 11 7 4 2 1 2. Ila and Ibema. Their demand curves for Smile are given below. a product was selling for Rs. Ifraah. . 14 and as a result the quantity demanded changes to 500 units. (b) substitute goods. (b) one and (c) infinity. mobile phone and school uniform. 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. How is the market demand curve derived from the individual demand curves? There are four consumers of a fruit called Smile.38 2. Which of the following commodities have inelastic demand? Salt.34 2.36 How does an increase in income affect the demand curve for an inferior good? Define (a) complementary goods.

The price elasticity is 2. From this.48 2. A dentist was charging Rs. The price elasticity is 0.5. What is the % change in price? As the price of peanut packets increases by 5%. what can we conclude about the elasticity of demand for such a dental service? . As a result.43 2. Find the % change in quantity. 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. She has since last month increased the price of dental cleaning to Rs. Choose any three points on it and compare the point elasticities at these three points. B and C. Consider the above straight line demand curve.5%. 33. fewer customers are now coming for dental cleaning.250.000.45 2. Compare the point elasticities between the points A.50 Draw a straight line demand curve.44 2.42 INTRODUCTORY MICROECONOMICS 2. but the total revenue is now Rs. 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%. 350.42 2.46 2. 300 for a standard cleaning job and per month it used to generate total revenue equal to Rs.49 2. 30. The % change in price is equal to 5. 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. The % change in quantity is 4. the number of peanut packets demanded falls by 8%.47 2.

How will this affect the demand curve for bus travel between the two cities? Section III 2. 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. a family’s spending on the product has to increase. the Government of India suggests Indian Airlines to reduce air fare to Goa from the four major cities.CONSUMER CHOICE AND THE DEMAND CURVE 43 2.54 2. Chennai.” Defend or refute. 2. Many people who were previously unemployed in the area are now employed.52 “If a product price increases. Andre and Tim.53 Discuss how the market demand curve is derived from the individual demand curves and the determinants of market demand. Kolkata. Their demand schedules are given in the following table. 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. Determine how the following changes (or shifts) will affect market demand curve for a product. If the Indian Airlines reduces the air fare to Goa.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 . Mumbai and New Delhi. Suppose there are three consumers in a particular market: Leander. Suppose that the train fare between the two cities comes down.51 2. Explain why consumer’s equilibrium is attained when the marginal utility of a product in terms of money is equal to its price. (a) A new steel plant comes up in Jharkhand.

Marat. Derive the new market demand curve. (b) Suppose Andre drops out of the market. . joins the market.57 (a) Derive the market demand schedule and plot the market demand curve.44 INTRODUCTORY MICROECONOMICS 2. (c) Suppose Andre stays in the market and another person. 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.56 2.

I I I PRODUCER BEHAVIOUR AND SUPPLY .PRODUCTION AND COSTS 45 U N I T.

. In this chapter in particular. we study important concepts associated with production and costs. inputs have to be paid.500 = Rs. In Chapters 3 and 4 we will be concerned with the producer’s behaviour. 20 each.1 By definition. 1 In this chapter and others. 6. you produce and sell 500 hammers.000 – Rs.2 Costs In Chapter 2 we studied the consumer’s behaviour. 6. suppose that you are in the business of making hammers. In turn. 10. Then the total revenues generated are equal to price × quantity.500. Rs. equipment and raw materials.000. The sum total of payments to all inputs is the total cost of production. 10. during a month.1 Production 3. and. we will use the term “profit” or “profits”. 3.500. Both are correct uses. They are selling at the price of Rs. This is a technological relationship. Then your profit is equal to Rs. As an example. that is. Producing hammers requires inputs such as labour.46 INTRODUCTORY MICROECONOMICS CHAPTER 3 AND PRODUCTION COSTS • • 3. profit earned by a firm is equal to its total revenues minus the total costs. A producer or a firm is in business to maximise profit. 20 × 500 = Rs. Let the total cost of making 500 hammers over the month be Rs. building.

we will analyse that between output and payments to inputs. the amount produced. output is linked to inputs via technology.1 Production Function The most basic concept here is what is called the production function. labour (measured in hours) and land (in acres). In Section 3. and. 3.1. which is called production function (to be defined in a moment). the employment of inputs leads to their payments. say. we will study the relationship between inputs and Table 3. output. 2 hours of labour and 4 acres of land produce at the most Fig. 1 hour of labour and 2 acres of land produce at the most 5 units output.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 . This chain links output to costs.1 lists some factor combinations and the corresponding output levels. On one hand. or.1.1. In section 3. On the other hand. and. Table 3. 3.1 PRODUCTION 3. For instance. what is called output. 3.2.1 Linkages These linkages are depicted in fig. The link between output and revenues will be examined in Chapter 4 (and in Chapter 6 also).PRODUCTION AND COSTS 47 The above example is illustrative of some important linkages. is linked to total revenues in the product market. defined as a technological relationship that tells the maximum output producible from various combinations of inputs. a firm employs only two factors or inputs.

instead of “maximum” output. A numerical example showing a TPP schedule is given in 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 3.3 3. where the variable input.1 gives only some. . not all. Also.. The next one is marginal product or marginal physical product (MPP).. One is total product or total physical product.2 Note that the notion of production function is not just confined to two inputs. Table 3. 2 hours of labour combined with 4 acres of land produce 11 units of output.g. These are respectively similar to the concepts of total utility and marginal utility discussed in Chapter 2. raw material etc. These are also respectively called total. i.48 INTRODUCTORY MICROECONOMICS 11 units of output. is called labour. If we graph a TPP schedule. A reasonable way to assess this will be to vary the employment of one input while keeping the employment of other inputs fixed. There can be other inputs like capital. we can differentiate between unskilled labour and skilled labour. APP = TPP/L. denoted by TPP. marginal and average returns to an input.2 Returns to an Input A production function given in the tabular form such as in Table 3. where L is the level of employment of the variable input. e. we just say output. possible combinations of inputs and output. It is normally assumed that inputs work to the best of their efficiency. 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. Three concepts arise in this experiment. Finally.4 When the employment of an input changes. we call it a variable input. It simply defines the total output at a particular level of employment of an input when the employment of all other inputs is unchanged. L. and so on.1 does not reveal much about the contribution of a single factor towards production. we define Average Product or Average Physical Product (APP) as the TPP per unit employment of the variable input.1. we get a total physical product curve.e.2. Hence.

The MPP schedule corresponding to the TPP schedule in Table 3. 3.3 and 3. is obtained through dividing TPP by L in Table 3.2 is given in column (2) of Table 3.2. which is 10. MPP and APP are applicable to The marginal physical product. which is 12. given in column (3) of Table 3.3 are given respectively in figs. Likewise. TPP. Table 3.4. is derived from the total physical product.2 the MPP at L = 2. is equal to the difference between TPP at L = 2. These graphs corresponding to Table 3. Note the following : 1. For instance. MPP. The graphs of an MPP schedule and an APP schedule are respectively called the marginal physical product curve and the average physical product curve.2 shows the TPP curve for the TPP schedule given in Table 3. the APP schedule. which is 22.2 The Total Physical Product Curve Corresponding to Table 3. just as marginal utility is obtained from total utility.75 10.3.3 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 10.3. 3.2.20 9.33 8 6 4 Labour Hours employed (L) 0 1 2 3 4 5 6 7 8 9 . 3.PRODUCTION AND COSTS 49 Fig. and TPP at L = 1. It is not true that the concepts of TPP. Fig.

3 equipment). 2. but one at a time. Similarly. when the level of an input’s employment is sufficiently low. For example. labour) and not to others (e.3.3. if the APPs are known. land or Fig. Law of Variable Proportions and Law of Diminishing Returns As we will see later in this chapter and in the next. 3.3 The Marginal Physical Product Curve Corresponding to Table 3. This pattern of MPP is called the Law of Variable Proportions. TPP must be decreasing as the level of the . we get TPP by multiplying APP with the level of employment. MPP is negative in this range. TPP decreases from L = 8 onwards. In Table 3.g. Put differently. TPP is the sum of MPPs ( just as total utility is the sum of marginal utilities). in general. the MPPs at L = 1.2. in Table 3. It is applicable to all inputs. we see that MPP is positive in this range.g. given any one of these.2. This relationship is verified from TPP and MPP schedules. 4. The MPPs being additions to the TPP also implies that if MPP is positive. the most important schedule (curve) from our viewpoint is the marginal physical product schedule (curve). its MPP increases. this law outlines three stages of production.3 that the MPP initially increases with an increase in the employment of the input in question. Then we can get TPP by adding MPPs (as TPP is the sum of MPPs). we can readily obtain APP by applying its definition. it decreases but remains positive. in stage Fig. 3.4 The Average Physical Product Curve Corresponding to Table 3. In stage I.3 variable input increases. In stage II. Since MPPs are additions to the TPP. from Table 3. the TPP at L = 3 is equal to 33. TPP increases up to L = 6.50 INTRODUCTORY MICROECONOMICS one particular input (e.3. TPP must be increasing and if MPP is negative. In Table 3. Once we get TPP. then it diminishes and finally it becomes negative. 3. Then MPPs are obtained by applying its definition. in Table 3. 2 and 3 add up to 33.2. Suppose MPPs are given to us. In Table 3. and. Although we have derived MPP and APP from TPP above. We notice from fig. we can derive the other two. finally. 3.

stage III sets in at L = 8. which marks stage II. But in stage III. and. Fig. but. it will get less revenues. The significance of these stages of production is that a profit-maximising firm will never operate in stage III. stage I holds till L = 2. at the same time. by entering stage III. It is because. the factor proportions become initially more suitable for production. Suppose that the input can be measured continuously like points on a line. in the output market. and. In our example. it goes by the name of the law of diminishing returns. it becomes negative. it is the stage III. We observe that the MPP increases between 0 to A. called the law of diminishing marginal product or the law of diminishing marginal returns (which is similar to the law of diminishing marginal utility). as more of a particular input is used in production. This region marks stage I. wherein the MPP is negative. but we will learn in Chapter 7 that a profit- Fig. TPP increases with the employment of the variable input as MPP in this range is positive.PRODUCTION AND COSTS 51 III. A smooth MPP curve is drawn in fig. Diminishing returns holds in stages II and III. That leaves out only stage II. after a certain level. From the point B onwards. after a certain level. 3. This implies that profits will be less. stage II is operative between L = 3 and L = 7. in which the marginal returns to an .5 Three Stages of Production and Diminishing Returns maximising firm will not operate in stage I either. As the employment of a particular input gradually increases while all other inputs are kept unchanged. It is not obvious at this point. 3.5. a firm will have to incur higher costs on one hand (as it is hiring more of the input). not just in integer units like 1.5 illustrates these laws more clearly. since output is falling. Then the resulting TPP. The reason behind the law of variable proportions or the law of diminishing returns is fundamentally the same. MPP and APP curves will look smooth. The MPP diminishes but remains positive between A to B. 2. the variable factor can work with other given inputs only less efficiently. that is. factor proportions become increasingly unsuitable for production. Note that in stages I and II. This says that. the employment of other inputs remaining the same. its marginal physical product decreases with further employment of it. Closely associated with this law is another important law. it decreases since MPP is negative. 3. 3 etc. More briefly.

1. “diminishing” or “constant” mean that the output decreases or remains 5 constant: the output always increases when all inputs are increased. Finally. Constant returns to scale hold when output increases exactly by the proportion in which inputs are increased. 3. instead of increasing one input at a time. from C to D.52 INTRODUCTORY MICROECONOMICS input is positive but diminishing. For example.1 Short Run Fixed and Variable Costs At a given point of time. As fig. (b) by less than 20% or (c) exactly by 20%? The possibilities (a). the output is going to increase. The effect of this change on output is captured by the notion of returns to scale. In other words. Fixed costs are those that do not vary with the level of output. (b) and (c) respectively illustrate increasing returns to scale. by 20%).5 The production function outlined in Table 3. from B to D there are increasing returns to scale. and. inputs increase by 50% but output increases by more than 50% (as 18 is more than 50% higher than 11). suppose all inputs are increased by a given proportion. Of course. you increase the employment of all inputs by the same proportion (e. but output (equal to 11) is more than double of the output at combination B.3 Returns to Scale Suppose that. cost concepts are very much related to concepts associated with the production function. i.2. (These are also called overhead This holds as long as the MPP of each factor is positive. Compared to B. this is the most relevant stage. 1 unit of labour and 2 units of land produce 5 units of output. In turn. But by how much? Will it increase (a) by more than 20%. . this implies that the APP curve is inverse U-shaped also. You should not make the mistake that the ter ms “decreasing”. the firm is not operating in stage III. there are constant returns. 3. in the range from D to F. From the viewpoint of the operation of the firm. 3. Increasing (respectively decreasing) returns to scale hold when output increases more (respectively less) than proportionately. a firm faces two types of costs: fixed costs and variable costs.e. decreasing or diminishing returns to scale and constant returns to scale.2 COSTS We now move on to discuss some cost concepts. Likewise. This point will be clearer as we go along. finally from F onwards there are decreasing returns to scale.g. the combination C has double the amount of each input.1 contains stages showing all three types of returns to scale. 3. Why? In combination B.. you can calculate that. note that the law of diminishing returns implies that the MPP curve is inverse U-shaped.1 suggests. Similarly.

PRODUCTION AND COSTS 53 costs. hire more workers and so on. By definition. you have to buy more cotton and other raw materials. Variable costs increase with output. Notice that. by definition. labour costs and costs of raw materials. Average Costs If we divide total fixed cost and total variable cost by output. Instead of being termed simply fixed and variable cost. by dividing total cost by output.e. ATC = AFC + AVC. Figure 3. together with the total cost curve that graphs the TC schedule. do not change with output. Notice that TFC. That is. But TVC. If you want to produce more garments. In other words. The columns (2) and (3) against column (1) are respectively total fixed cost and total variable cost schedules.. at the zero level of output. They refer only to different periods of planning horizon by producers in an industry. having more or less number of machinery depending on your business outlook for the future.g.4 presents a numerical example. by definition. e. Hence. fixed insurance payments for your machinery against fire etc. in a long run horizon. we respectively get the Average Fixed Cost (AFC) and the Average Variable Cost (AVC).4. Similarly. we return to the short run situation. you operate a garment factory. these curves are upward sloping. they can vary from one industry to another. Besides fixed cost. That is. i. we obtain the Average Total Cost (ATC). The AFCs. the total cost curve is the vertical summation of the total fixed and total variable cost curves. However. fixed costs are present only in the short run. Table 3. since TVC and TC increase with the output. not in the long run. that are fixed in the short run can vary in the long run. these are formally called Total Fixed Cost (TFC) and Total Variable Cost (TVC). TC = TFC. Average total cost is sometimes loosely called average cost only. given in column (3).. Total cost (TC) is then. Graphs of these schedules are the total fixed cost curve and the total variable cost curve respectively. Hence the rent and insurance costs etc. AFC = TFC/Output and AVC = TVC/ Output. even if these costs are fixed at any given point of time or within a short time period. does. You pay a fixed rent for the factory building. given in the last column of Table 3. ATC = TC/Output. Having noted this difference. because TVC is zero when output is zero. total fixed costs + total variable costs. The TFC curve is horizontal because fixed costs do not change with the output. the AVCs and the ATCs corresponding to . there are variable costs − those that change with the level of output.) For example. These are independent of how many garments per month you produce. you can think of renting more or less space. Note that. Note that these notions of short run and long run do not refer to any particular calendar time. There is a time element in interpreting these costs as fixed.6 depicts these. given in column (2).

) 10 10 10 10 10 10 10 10 10 10 ATC curves slope downwards initially and then upwards. this is defined as the increase in total cost when one extra unit is produced. 45 = Rs. the marginal cost (MC).e.4 is given in Table 3. It is because the 7th unit of output costs Rs. The AFC curve continuously decreases as output increases. The reason behind this shape will be discussed later. Similar to marginal utility or marginal product. i. Fig.6. In the example given in Table 3. The AVC and .4 Table 3.4 are given in Table 3.54 INTRODUCTORY MICROECONOMICS Table 3. because the numerator of the ratio TFC/Output is constant while the denominator increases.4 Output 0 1 2 3 4 5 6 7 8 9 Total Fixed Costs and Total Variable Costs Total Variable Costs (Rs.7 graphs them. 12. 12. suppose that the current level of output is 7.4. 3.5. Thus. The MC schedule corresponding to Table 3. 3.6 TFC.) 10 18 23 26 30 36 45 57 73 93 Total Fixed Costs (Rs. it is the (additional) cost of producing an extra unit. Marginal Costs There is another important cost concept. they are U-shaped. The MC of this output level is Rs.) 0 8 13 16 20 26 35 47 63 83 Total Costs (Rs. and fig. 57 – Rs. TVC and TC Curves corresponding to Table 3.

) 10 5 3.50 8. Assuming that the output is per fectly divisible. For example. This result will be used in Chapter 4. Fig. It is the marginal cost curve.25 1. 8) and that of producing two units (= Rs. 13.5 Note that.20 7.8 graphs the MC schedule given in Table 3.14 9.33 5 5. Moreover. this is the sum of the MC of producing one unit (= Rs.66 1. AVC and ATC Schedules (Based on Table 3. That is.71 7.PRODUCTION AND COSTS 55 Table 3. .) AVC (Rs. Recall that the TVC is sum of the marginal costs.4) AFC (Rs.33 Fig.50 7.7 AFC.43 1.22 18 11. a smooth (hypothetical) marginal cost curve is drawn in fig. the TVC is equal to the area under the marginal cost curve.50 2 1. at output q0 .9.11 8 6. AVC and ATC Curves Corresponding to Table 3.) ATC (Rs. the TVC of producing 2 units is Rs.6. since total costs and total variable costs differ only by a constant term (equal to the total fixed cost). 5). and. For example. the TVC is equal to the area 0ABq0 .84 6. TVC is equal to the sum of MCs (just as total utility is the sum of marginal utilities).875 9.125 10. 3.33 2.50 8. 3. This implies a property associated with a smooth marginal cost. 3.20 5.50 5.66 7.5 Output 0 1 2 3 4 5 6 7 8 9 AFC. MC can be equivalently defined as the increase in the total variable cost when one extra unit is produced.

This implies that. after certain point. Let us suppose that this particular input is the only variable input. and. it will be more and more.) 8 5 3 4 6 9 12 16 20 unchanged. so that the total payment to it is equal to the total variable cost. after a certain point. the MC curve is initially decreasing in output and then it is increasing. it is U-shaped. 25 20 15 10 5 0 0 1 2 3 4 5 6 7 8 Marginal Costs (based on Table 3. the total payment to which is the total fixed cost. an increase in any given input leads first to an increase in its marginal physical product. which are kept unchanged. As you recall. as the fixed factors. as more and more output is produced.6 Let us now turn around the statement of the law of diminishing returns and say equivalently that. Similarly. interpret the other inputs. as other inputs are kept Table 3. then. and. Fig. the rate of increase in the requirement of the variable input will be less and less. 3. initially. The reason behind the Ushape of the MC curve is the law of diminishing returns.4) Marginal Cost (Rs.9 A Smooth Marginal Cost MC Output 9 10 Fig. initially. 3. 3.e. the rate of increase in the variable cost − which is same as the marginal cost − will be less and less as output increases.8 The MC Curve corresponding to Table 3. it will be more and more when output .6 Output 0 1 2 3 4 5 6 7 8 9 Costs in Rs . 3.8 or fig.9. and then.56 INTRODUCTORY MICROECONOMICS As you see from fig. i. this law says that. leads to a decrease in its marginal physical product.

You calculate the average again and find that it has increased from 49 runs. Has then the fourth batsman.PRODUCTION AND COSTS 57 increases further. 1983.6 Once we know that the MC curve is U-shaped. Chapter 7. 3. There is indeed another relationship that holds between AVC. AVC is increasing in output. The reason behind this is mathematical. Hence the above logic applies to the relationship Indeed. scored more or less than 49? The answer is “more. 3.” Why. the fourth batsman must have scored less than 49. the “marginal” should be above (respectively below) the average. Consider fig. The runs scored by those already out are say 40. Suppose that you are interested in calculating the average score of batsmen out as wickets continue to fall. (b) at any output greater than q 0 . Similarly.10. By definition. the MC curve is a mirror reflection of the MPP curve. Observe that the MC curve cuts the AVC and ATC curves at their minimum points. The Logic of Markets. Likewise. This is contained in Richard Manning and Kenneth Henry. Now. The Dunmore Press Limited. The AVC curve is decreasing in the range of output from 0 to q0. .10 AVC. when 3 are already out). ATC and MC curves. MC is the addition to both the TVC and the TC. it follows that the AVC and the ATC curves are U-shaped also. because otherwise the average wouldn’t have increased. This explains the Ushape of the MC curve. Then it must be true that.e. who got out.7 Consider the game of cricket. if the average had fallen from 49. hence MC > AVC.10. Now go back to fig. statements (a) and (b) together imply that the MC curve must cut the AVC curve at the AVC’s minimum point. ATC and MC Curves “additional” runs scored by the next “unit” or batsman. which depicts smooth AVC. This simple deduction means the following. say. and. We are then saying that if the average increases (respectively decreases). (a) at any output level in this range. ATC and MC curves. 6 7 Fig. MC < AVC. Begin to calculate this after. Think of the runs scored by the fourth batsman out as “marginal” (i. 3 wickets are down. it can be understood through the following example. The average is (40 + 105 + 2)/3 = 49. 105 and 2. New Zealand. The game goes on and the fourth wicket falls. not economic. 3.

. 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. Like the short run average and marginal cost curves. since all inputs are variable. there is no distinction between average total costs and average variable costs and we will use the term “long-run average cost”. inputs need to be increased only by less than proportionately (say by 7%). we will abbreviate it to LMC. 3. 8 8 In particular. are U-shaped. because costs that are fixed in the short run can be changed if the planning horizon of the producer is long enough.2. the LAC curve is flatter than short-run average variable cost curves. if returns to scale are constant. The former cuts the latter at its minimum point too. The concept of marginal cost remains exactly the same however. which determines the U-shape of these curves. in general. denoted by LAC. decreasing returns to scale imply that the average cost must rise with output. all inputs are variable. the average cost is constant − independent of output. This implies that the average cost must fall as output expands. 3. Instead. there are no TFC or AFC curves in the long run. Accordingly.” Similarly. Now look at fig. It shows a U-shaped LAC curve. However. we discuss the shapes of the LAC and LMC curves. the reasons behind their shapes and the relationship between them. we simply use the term “total costs.11 The Long-Run Average and Marginal Cost Curves The short-run and long-run average or marginal cost curves are not unrelated however.11. it is the pattern of the returns to scale. Similarly. increasing returns to scale mean that if output is increased at a given rate (say 10%). This means that.2 Long Run Recall that. the LAC and LMC curves. In what follows. Finally. and. where L stands for long run. as output is gradually increased Fig. 3. As you will learn in a higher course in microeconomics. There is no distinction between total costs and total variable costs. the reason behind the U-shape is not the law of diminishing returns.58 INTRODUCTORY MICROECONOMICS between MC curve and ATC curve also. the LMC curve cuts the LAC at its minimum point. in the long run.

it 9 plans to buy 200 tons of yarn it can negotiate a better price. constant and decreasing returns to scale are written in short forms as IRS. In this case. The concepts developed in this chapter will be used very much in the following chapters. Now. suppose that a fir m has only o ne manag er. then there are constant returns to scale (at q0). the U-shape of the LAC curve implies the U-shape of the LMC curve. Storing merchandise and taking them out generate traffic. the LAC will have a flat portion in the middle. a firm experiences constant returns to scale. given that initially increasing returns. Crowding and congestion occur typically. instead. increasing. which lead to decreasing returns to scale. a firm would be able to reap the advantages of (a) division of labour and (b) volume discounts. . Now the question is why do IRS occur first. as the firm increases its production and hires another manager who expertise is in manufacturing. one of them can be used as storage only and as a result the productivity of employees will improve. The same applies to other kinds of workers and to machinery and land. difficulties in managing an enterprise crop up. 3. In between IRS and DRS. Second. This is called division of labour. such as at point q0. If. the long run average cost is minimised where constant returns to scale prevail. For instance. 9 In case of volume discounts. this is the level at which production is most efficient. In some sense. as the output level goes beyond a certain limit. A couple of remarks are in order: First. where the U-shape of the marginal cost curve implies the U-shape of the average cost curve. rather than at a single level of output. at a small scale of operation. there are increasing returns to scale (in the output range 0 to q0) such that LAC falls. a garment factory buys 100 tons of yarn at a certain price.11. then constant returns and finally decreasing returns to scale occur as output increases. such that LAC increases with output. To cite an example in case of for mer. the firm acquires an additional room.11. 3.PRODUCTION AND COSTS 59 starting from a small level. then each manager can specialise in their expertise and be more efficient. and finally decreasing returns to scale prevail at output levels higher than q0. If. the firm may have only one room. which is used as a storage as well as office space for its employees. instead. for instance. More generally. meaning allocation of tasks according to the specialisation of workers. CRS may prevail over a range of output. It is shown at point q0 in fig. This is different in nature from the short run. However. CRS and DRS respectively. as the scale of operation increases. followed by CRS and DRS? Starting from a relatively smallscale operation (output). wh o s e speciality is in marketing but who is looking into both marketing and manufacturing. which would adversely affect the productivity of other employees. In fig.

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

(c) Cost of raw materials. (e) Interest on capital. (b) Minimum telephone bill.19 3.21 3.6 3.PRODUCTION AND COSTS 61 EXERCISES Section I 3.12 3. 3. Classify the following into fixed cost and variable cost. Give the meaning of decreasing returns to scale.18 3.16 3. (h) Daily wages.2 3. 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 3.11 3. (a) Rent for a shed.7 3. (f) Payment for transportation of goods.1 3.5 3. (g) Telephone charges beyond the minimum.15 3.10 3.4 3.8 3.9 3.24 . 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.20 3.22 3.13 3. (d) Wages to permanent staff.23 3. Give the meaning of constant returns to scale.14 What is a production function? List any three inputs used in production.17 3.

.27 TPP 0 5 12 20 28 35 40 42 The following table gives the MPP of a factor. Level of Factor Employment 1 2 3 4 5 6 MPP 20 22 18 16 14 6 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. It is also known that the TPP at zero level of employment is zero.62 INTRODUCTORY MICROECONOMICS Section II 3. Determine its TPP and MPP schedules.28 The following table gives the APP of a factor.25 3. Determine its TPP and APP schedules. Level of Factor Employment 0 1 2 3 4 5 6 7 3. It is also known that the TPP at zero level of employment is zero.

TFC and TVC. 37. Find out the total fixed cost of this firm. Output (in units) 0 1 2 3 4 5 6 7 8 Total Cost In (Rs.32 3. At this level of output.35 3.PRODUCTION AND COSTS 63 Level of Factor Employment 1 2 3 4 5 3.34 3. 40 and Rs. Do ATC and AVC curves intersect? Give reasons.31 3. Section III 3.29 APP 50 48 45 42 39 3. explain the relationship between TC. With the help of a suitable diagram. the ATC and AVC are respectively equal to Rs.33 3. 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.36 6 35 Explain the law of diminishing marginal returns.) 40 120 170 180 210 260 340 440 550 .30 3. In other words. Why is the MC curve in the short run U-shaped? A firm is producing 20 units.37 A firm’s total cost schedule is given in the following table.

38 What is the total fixed cost of this firm? Derive the AFC. Complete the following table if the AFC at 1 unit of production is Rs. 60. Output (in units) 1 2 3 4 5 6 7 Marginal Cost (in Rs.) 2.000 2. ATC and MC schedules.000.500 1.700 3.500 2.500 . AVC.200 1. Compute the TVC. TC and ATC from the following table.000 1. 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 firm’s fixed cost is Rs. 2.64 INTRODUCTORY MICROECONOMICS (a) (b) 3. AVC.

PRODUCTION AND COSTS 65 3.41 3. 100. Tables A and B below outline two production technologies or production functions. 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 . and the marginal cost schedule of a firm is the following. Show that the production function given in Table A satisfies increasing returns to scale and that in Table B satisfies decreasing returns to scale. There are two factors: unskilled labour and skilled labour.40 Suppose that a firm’s total fixed cost is Rs. AVC and MC with a suitable illustration. Output (in units) 1 2 3 4 5 6 7 Marginal Cost (in Rs.42 Is the MC curve U-shaped? Derive the AVC schedule.) 10 20 30 40 50 60 70 (a) (b) 3. Explain the relationship between ATC. Will the AVC curve be U-shaped? Discuss why or why not.

66 INTRODUCTORY MICROECONOMICS Table B Unskilled Labour (in hours) 8 10 12 14 3.” Defend or refute.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. .

REVENUES. we saw that profits are equal to the difference between total revenues and total costs. In the last chapter we studied concepts associated with production and cost. In the last chapter. This sets the stage for analysing profit maximisation or what is called producer’s equilibrium. But we did not learn about their choice behaviour i.e. which are relevant for producers. the supply curve shows different quantities produced and sold at different prices. PRODUCER’S EQUILIBRIUM AND THE SUPPLY CURVE Besides the demand forces. forms the basis of what is called the supply curve. it would like to “stay” or “rest” at that level of output.5 • • • 4. This. We also discussed how total costs change with output. we study profit maximisation. PRODUCER'S EQUILIBRIUM AND THE SUPPLY CURVE 67 CHAPTER 4 REVENUES. change with output. the supply forces constitute the other crucial component of market mechanism.6 Time Horizon 4.1 Total Revenues 4. It is an equilibrium notion in the sense that if the firm selects the level of output at which profit is maximised. Comparable to the demand curve.3 Change in Quantity Supplied Versus Change in Supply 4. we first analyse how total revenues. and. defined as price × output. In this chapter we develop the revenue concepts. It is the producers who supply goods and services to the market. together with the cost concepts. which level of output they should produce so as to maximise their profits.7 Price Elasticity of Supply .2 Producer's Equilibrium: The Basis of the Supply Curve 4.4 Determinants of Supply Curves Market Supply Curve • 4. in turn. In this chapter. there is • • • 4.

Other types of market structure will be studied in Chapter 6. This does not mean that the market price itself cannot change. 4. 4. there are typically many producers of these items. identical) product or service. perfect competition. each firm is a price taker in perfect competition. which is of central importance in economic analysis. But. Why would anyone pay more for exactly the same item? Hence. There are black and white TVs as well as colour TVs.e. (A) There are a large number of buyers and sellers (producers). (C) There is free entry and exit. How it may change will be studied in Chapter 5. In this chapter. it is essentially the same everywhere. the effect of a change in output on the total revenue of a firm depends on the market structure. (F) No transport and selling costs. again. Because. namely. say. The chosen examples are different from.1. a standard haircut may differ slightly from one barber to another. naturally homogeneous. . But.1 Perfect Competition The following six characteristics define perfect competition or a perfectly competitive market. i.1 The implication of the product being homogeneous or identical is that all firms have to charge the same price for the product. for most practical purposes. which exactly fit the definition of perfect competition. no one will buy from the former.. That is. But the markets for goods and services like wheat. That is because if one producer happens to charge a price higher than some other.68 INTRODUCTORY MICROECONOMICS no incentive for it to increase or decrease output from that level. Each of these is a standardised item.2 An example may help to better understand the price taking behaviour. TVs differ not just in quality but also in style and design. the differences are negligible. (E) Uniform price. all producers who operate in the market must charge the same price. the nature of competition between them and the nature of the product. Think of a product like jalebi (a sweet). we will consider only one kind of market structure. (B) Firms sell a very homogeneous (i. the market for TVs.1 TOTAL REVENUES Unlike costs. Even in the category of colour TVs. Similarly. which are very close to perfectly competitive markets. If you operate a halwai (sweetmeat) shop in a big town in which there are many such halwai shops. which are differentiated.e. which refers to the number of firms operating in an industry. 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. (D) Perfect knowledge. there are 19" TVs and 29" TVs. 2 You can of course argue that there may be some differences between wheat produced in Punjab and wheat produced in Australia. Moreover. It is hard to find markets. it is relatively easy to enter or get out of these businesses. a standard hair 1 cut or a leather football can be thought of as examples of industries.

the total revenue is equal to the area under the price line. because being small compared to the market. the TR is Rs.1. free entry and exit.2. 70.1. 4. Moreover. *Market price jalebi = Rs.1 reports the total revenue schedule for this example. Then.1 Total Revenue Schedule Output In Kg. That is.3 Total Revenue Curve and Price Line If we graph the total revenue schedule. 4. Table 4. This is seen in fig. does not have any direct bearing on how TR changes with respect to output. 70/kg 3 The feature (C) of perfect competition. Thus you will be a price taker. in which AB is a hypothetical price line. 70 × 5 = Rs. all customers). possibly. This is depicted in fig. 4. The y-axis measures price. 350. it is Table 4.2 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.) There is a relationship between the price line and the total revenue. If you sell six. 0 1 2 3 4 5 6 7 8 TR (Rs. 70 too.3 For example. PRODUCER'S EQUILIBRIUM AND THE SUPPLY CURVE 69 and.1(a). TR is obviously zero. . it is a straight line. This is because the market price is independent of how much quantity is sold by one firm. Hence the TR curve must pass through the origin. we obtain the total revenue curve. which is the area under the price line. Obviously. 4. Its implication will be studied in Chapter 6. not total revenues. measuring output along the x-axis and total revenue along the y-axis. This is called the price line. you will charge Rs. 70 (and lose a lot of. There is also no reason for you to sell at any price less. (The price elasticity of this demand curve is infinite. Suppose that the firm is producing the amount q0. Turn to fig. you will not charge more than Rs. we obtain a horizontal line. At zero output. It is also called the “demand curve facing a competitive firm” in the sense that. TR = price × quantity = OA × Oq0 = OADqo. 4. the market price of jalebi per kg is Rs. Since the market price is given or “exogenous” to the firm. 420 and so on. it is quite simple to relate total revenue (TR) to output. if you sell five kilograms of jalebi. from a firm’s perspective. it is able to sell to the consumers any amount it wishes at the same price.REVENUES. you can “sell” as many jalebi as you like at the going price in the market.1(b) now.) 0 70 140 210 280 350 420 490 560 Rs. namely.

The question is at what level of output will a firm’s profit be maximised? Unlike the numerical method that was used in Chapter 2 to study consumer’s equilibrium. it is the revenue obtained from one extra or last unit sold. Thus. which is not perfectly competitive. This is not true for a firm. Marginal revenue is defined as the increase in total revenue when one extra unit is sold. Note that. It is equal to TR/output..70 INTRODUCTORY MICROECONOMICS (a) (b) Fig. the extra r evenue generated will be equal to whatever the price is. if it sells one extra unit. AR is always equal to price. for a competitive firm. i. In order to do so. MR = price.1 4.2 PRODUCER’S EQUILIBRIUM: THE BASIS OF THE SUPPLY CURVE We are now ready to study producer’s equilibrium. 4. the terms of AR and MR will not be used much in this chapter. .4 Average Revenue and Marginal Revenue These are two more “revenue” concepts.1. we need two results from our study of costs and revenues: Fig.2 Price Line and Total Revenues 4 5 This is similar to the concept of marginal utility or marginal cost. Here they are introduced for the sake of completeness. since TR = price × output.4 Since a competitive firm is a price taker. Average Revenue (AR) is defined as revenue per unit of output.1 Total Revenue Curve and the Price Line corresponding to Table 4.e. But they will be in Chapter 6.5 However. we use a graphical method to answer this question. 4. 4.

since TFC is constant. We now argue that. In other words. To see this. profit is maximised where gross profit is maximised and vice versa. the gross profit is maximised at the output q0. hence profits. 6 say q'.3. suppose that. at any level of output either less or greater than q0. the key reason behind the producer’s equilibrium condition.2. By definition. we are saying that.6 Why is profit maximised where the price line intersects the MC curve? Define gross profit equal to TR – TVC. i. and TVC = the area under the MC curve = 0DAq0 . with P denoting the market price. The total revenue is equal to the area under the price line. this is equal to profit plus TFC.2 Rationale Behind the Condition. is that marginal cost be increasing with output. Fig. thus gross profit = 0P 0 A"q" – 0DCq" = DP0A – ACA". . At which level of output is the firm’s profit maximised? The answer is q0. This proves that gross profits. say q". Its marginal cost curve is denoted by MC. Thus gross profit = 0P0Aq0 – 0DAq0 = DP0A. the gross profit = DP0A'B. and. the gross profit is less. 2. This is also less than DP0A. 4.REVENUES.1 The Profit-Maximising Condition Turn now to fig. Hence. at the market price P0. Observe the similarity of this condition with the condition for consumer’s equilibrium in Chapter 2. P = MC. However. are maximised at q0. in general. Now consider any output less than q0.2. P = MC In Chapter 2 we saw that diminishing marginal utility is the key behind the consumer’s equilibrium condition of “marginal utility is equal to price. a level of output greater than q0. The total revenue is equal to 0P0A"q" and the total variable cost is equal to 0DCq". that is. This is the profit maximising condition or the condition for producer’s equilibrium. where P = MC. 4. Suppose that a competitive firm faces the market price P0. a competitive firm’s profit is maximised at the point where the price line intersects the MC curve. By similar calculation. where (A) P = MC. which stated that marginal utility be equal to price.3 Profit Maximisation 4.. The total variable cost is equal to the area under the marginal cost curve. starting from the level of output at which P =MC. P0A" is the price line. Look at next.” In a parallel way. PRODUCER'S EQUILIBRIUM AND THE SUPPLY CURVE 71 1.e. Notice that this is less than DP0A. 4. where the price line P0 intersects the MC curve. We have TR = the area under the price line = 0P0Aq0.

Hence. other things remaining unchanged. Similarly.4 Profit Maximising Outputs at Different Prices 7 a Suppose the firm is producing at q1 . suppose that the firm decides to produce one unit less than where P = MC. But P and MC are respectively equal to extra revenues earned and extra costs incurred. at q 1 . higher the price. The above discussion implies that. the profit-maximising b a output is q1 not q1 . and thus profit is a higher. MC decreases. marginal revenue is equal to marginal cost. 4. If it increases output by one unit. implying that the profits will be less. profits will also be less. Having noted this. the extra revenue generated is P1 and the extra cost incurred is equal to MC. Hence. the marginal revenue. and that P = MR for a competitive firm.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. profit is maximised where P = MC. Indeed. b a unlike at q 1 . . if at any given market price there is a level of output at which P = MC holds but MC is decreasing. we however return to P = MC as our profit-maximising condition for a competitive firm. as long as MC is increasing in output. Thus we can write (A) as MR = MC.4.2. a profit is not maximised at q1 . P1 > MC. That is. In summary then. At price P1.4 Law of Supply and the Supply Curve The law of supply states that. In this case the revenues sacrificed (equal to P) are greater than savings in costs (equal to MC). It is because. q1 and q1 . But since MC is decreasing. 4. Such a possibility is shown in fig. P will be now less than MC. Hence. 4.72 INTRODUCTORY MICROECONOMICS the firm decides to produce one unit more. 4. extra revenues will be less than the extra costs. the price line cuts the MC a b curve at two points.3 A More General ProfitMaximising Condition Recall the definition of MR. Thus. Given that MC is increasing in output. but. You can similarly argue that profit is less also if output is reduced by one unit from q1 . it cannot be the profit-maximising level of output. increasing or decreasing output from where P = MC results in less profits. this is a very general condition of profit-maximisation − something that holds irrespective of the market structure.2. an increase in the price of a product leads to an increase in the quantity supplied of it. Fig. the more a producer wants to supply. Therefore.

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. on many industrial goods.2 Since the supply curve is a part of the marginal cost curve. 4. technological changes and changes in factor or input prices. Hence all Table 4. The reason for this will be covered in a higher course in micro economics. and. Figure 4. the supply curve is only a portion of the rising part of the MC curve. the graph of a supply schedule gives the supply curve.5 The Supply Curve for the Supply Schedule in Table 4. Table 4.4. there are taxes that are based on the total production 8 Strictly speaking. at price P1. Besides. PRODUCER'S EQUILIBRIUM AND THE SUPPLY CURVE 73 “Other things” refer to other determinants of supply. 4. at price P2. 4. 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). stated in a tabular form. in India particularly.5 graphs the corresponding supply curve. gives rise to the supply schedule. This law. there are two such factors. .2 A Supply Schedule Price (Rs. which will be discussed later. whereas a change in supply means a shift of the supply curve due to a change in “other factors. We see that.4 DETERMINANTS SUPPLY CURVE OF THE Fig. What is the basis of the law of supply or the supply curve? Refer back to fig. the b firm produces the amount q1 . it produces q2. A change in quantity supplied refers to a movement along a given supply curve because of a price change.” It is now the time to discuss these factors.) 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.REVENUES.2 lists a supply schedule. Hence it follows that the rising portion of the MC curve is the supply curve itself ! 8 4. the factors that shift the marginal cost curve are the determinants of supply or the supply curve. Generally. and so on.

spread sheet and presentation packages. Column (3) lists the new one after the technological change. prices of essential goods typically rise. These are called excise taxes or excise duties. expecting to sell later at very high prices. the alphabets in the manuscripts used to be set in a frame and the frame would be mounted on a letter-press machine. The supply curve is also influenced sometimes by price speculations. we have the result that a technological progress shifts the supply curve to the right. Once manuscripts of books were prepared by authors in long hand. For simplicity. meaning that the marginal cost has decreased for any given level of output. Some private producers take advantage of this situation by “hoarding”. changes in the prices of related goods.6. 4. withholding supply of their product to the market. As we will see. namely. which can also shift the marginal cost curve.2 Input Price Changes Changes in raw material prices. we consider these determinants of supply. all tasks except for printing are done in a computer.12 Notice that each entry in Column (3) is smaller than the corresponding entry in Column (2). Consider for instance the printing business. there are many such examples. bringing out a book in print was a fairly complex process.4. in both cases. namely. 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. Changes are nearly costless to include. can also affect the marginal cost curve and the supply curve. Column (2) lists an old marginal cost schedule. There is another kind of technological progress that we do not consider here. The whole plate had to be changed if changes were to be made in the pictures or diagrams. In the real world. Since the MC curve is essentially the supply curve. This is an example of cost-saving technological change. But we ignore them here. The pictures and diagrams were etched on metal plates.1 Technological Changes printed pages are much less today than they were prior to 1980s. war. word processing. that is. The two marginal cost schedules are plotted in fig. As we can see. 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. a change in the rate of excise duty will also shift the supply curve. We ignore these factors in this chapter. In old days. 9 4. Table 4. There is still another factor that our simple profit-maximising analysis does not capture. In times of disasters like earthquake. . Using printers to print is also an easy and fairly inexpensive job.11 Such a technological advance lowers marginal cost at any given level of output. development of new products. famine and cyclones. the new MC curve lies below or to the right of the old one. The metal plate and the frame were mechanically inked and pressed on to paper to produce a page of the book. the marginal cost always increases with output.4. In what follows.3 illustrates this.74 INTRODUCTORY MICROECONOMICS cost of output of a firm. 4.10 Now a days. wages to workers etc. with computers.

In general then. you will employ fewer barbers and service less number of haircuts. an increase (a decrease) in the excise tax shifts the supply curve to the left (right).) 3 4 7 9 13 17 of an increase in input prices is shown in fig. As said earlier. 4. with their given amount of resources. As a result. Thus.4.3 A Decrease in Marginal Costs due to Technological Change Output 0 1 2 3 4 5 Old MC (Rs. Fig. these are taxes levied on the total production cost of a firm. 4. producers of various industries in the manufacturing sector pay excise taxes. this would increase the marginal cost and hence shift the MC curve and the supply curve to the left.4 Change in the Prices of Related Products Many producers. 4.) 7 8 12 14 17 22 New MC (Rs.7. Hence they add to the total variable cost. The case . The hourly market wage of barbers increases for some reason. a change in the rate of this tax affects the overall marginal cost.6 Technological Progress and Shift of the Supply Curve saloon.7 Increase in Input Prices and the Shift of the Supply Curve 4.REVENUES. Suppose the rate of excise duty on a particular product increases. For any given level of output.3 Changes in the Excise Tax Rate In India. PRODUCER'S EQUILIBRIUM AND THE SUPPLY CURVE 75 Table 4. 4. This will increase the cost of the haircut service that you provide and shift your marginal cost curve up or to the left. an increase (a decrease) in an input price shifts the supply curve to the left (right). Therefore. employ 10 barbers and service 120 haircut jobs a day now.4. manufacture or Fig.

where A2 and B2 are quantities supplied by producers (firms) A and B respectively. If the market price of wheat increases. In Chapter 2 the market demand schedule was obtained by numerically adding up individual demand schedules. All other points on the market supply curve are derived in the same manner. Here. the price of corn seeds) remain the same. SB and SA+B respectively denote A’s supply curve. Similarly at P2.8 Individual Supply Curves and the Market Supply Curve . The total quantity supplied to the market is then A1 + B1. In fig. B’s supply curve and the market supply curve. 4. 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). Consider a farmer who has a given amount of land. that shifts the individual supply curve and thereby the market supply curve. the technology of producing corn and input prices (e. 4. For example. 4. An increase (a decrease) in the number of firms shifts the market supply curve to the right (left). Hence. like a technological change or a change in any input price. This will shift the supply curve of corn to the left. the latter also shifts when the number of firms changes. 200 or whatever it may be). apart from any factor.76 INTRODUCTORY MICROECONOMICS grow more than one item. he will grow less corn even when the price of corn.5 MARKET SUPPLY CURVE This is parallel to the market demand curve. shown along the SA+B curve against this price. Fig. which he can use to produce wheat or corn (or both). It is derived as the horizontal summation of individual supply curves. the market supply curve is derived in an equivalent. Assume that there are two firms in an industry. It is because growing corn is less profitable now. Note that a market supply curve is derived on the assumption of a given number of firms (100.8 the curves SA. the total quantity supplied is A2 + B2. geometric way (so that you get to know both ways). at price P1 the producer A supplies A1 units and the producer B supplies B1 units. A and B.g. compared to growing wheat.

By definition. . we can also say that more (less) competition shifts the market supply curve to the right (left).REVENUES. As a rational producer. It is defined as (B) Price elasticity of supply = es As you know. entered into the production of small sized cars (Indica). PRODUCER'S EQUILIBRIUM AND THE SUPPLY CURVE 77 When there is an increase (a decrease) in the number of firms.1 Definition and the Percentage Method of Measurement Parallel to price elasticity of demand. it is that short a period within which firms cannot adjust their output to any change in price. in the passenger car market there were only two companies that were allowed to operate: Hindustan motors (with Ambassador) and Fiat (with Premier Padmini). which earlier produced only trucks and buses. the supply curve of a firm or the whole industry is vertical. as drawn earlier. because inputs can be changed.9. This will mean that your supply curve is upward sloping. This is good news for you. 4. especially since the 1990s. 2. you were producing 1 lakh chewing gums per month. more chemical engineers.7 PRICE ELASTICITY OF SUPPLY 4. As a result. Honda of Japan (Honda City) etc. as shown in fig.13 4. The market price that has been prevailing for a long time is one rupee a piece.7. you cannot make these changes. India has been following a path of economic liberalisation. Hyundai of South Korea (Santro). irrespective of whether the price may have changed to Rs.e. 1. 4. In a longer run − i. Suppose that you manufacture chewing gum. Your production level in a very short period of time is given. it takes time to hire people. However. more equipment etc.9 Supply Curve in the Market Period 4. Thus. The Indian automobile market is a prime example of this.50. Such a short period 13 is called the market period in economics. Fig. get new machinery etc.6 TIME HORIZON An element of time lies behind the supply curve being upward sloping. At this price. you would want to produce more by hiring more workers. Many foreign firms that couldn’t earlier enter the Indian market in different sectors can and do so now. we say that there is more (less) competition in the market. Thus liberalisation brings forth more competition. 3 or Rs. many foreign companies started to produce and sell such as Daewoo of South Korea (Cielo). Rs. an Indian Company. Until the seventies. in the short run or long run − the supply curve will be upward sloping. the price elasticity of supply quantifies the responsiveness of quantity supplied to changes in price. The resulting supply curve will be a vertical line. Even Telco. Within a very short period. In the 1980s came Maruti. In the 1990s. Now suppose the price increases to two rupees a piece. which is owned jointly by the Indian government and Suzuki Motor Corporation of Japan.

the price elasticity is positive. Hence S0 = 5. 10 and S1 = 8. Thus. Otherwise. extended towards the x-axis. 4. P1 = Rs. the % changes in price and quantity supplied are respectively [(P1 – P0 )/P0] × 100 and [(S1 – S0 )/S0] × 100. for very small price changes.7. 10 and you are producing and selling 8. if two supply curves intersect. Just as in case of price elasticity of demand. P0 = Rs. If the price rises to P1 and quantity supplied increases to S1. and [(S1 − S 0 ) / S 0 ] × 100 = [(8000 − 5000)]/ 5000] × 100 = 60. eS 60 / 25 2. then the price elasticity of supply is. obviously.2 The Geometric Method Also similar to point elasticity of demand. It shows three straight line supply curves. If the supply curve is vertical. the price elasticity of supply can be measured by a convenient geometric formula. intersects the x-axis in its negative (S − S 0 ) / S 0 ∆S / S 0 = (C ) es = 1 . As a numerical example. 8. let P0 and S 0 denote the original price and quantity. Panel (a) illustrates one. zero.000. given that the supply curve is positively sloped. 4. and (b). The reasons are exactly parallel what they were in case of price elasticity of demand.000 pens a month. in which the supply curve. Now its market price has increased to Rs.10 (b) (c) Price Elasticity associated with Straight Line Supply Curves .000. suppose that you manufacture one type of ballpoint pens. In this example. (a) the price elasticity of supply is independent of units. 8.10.4.78 INTRODUCTORY MICROECONOMICS % change in the quantity supplied % change in the price On a given supply curve. the flatter one has higher price elasticity at the point of intersection. Refer to fig. Hence. you produced and sold 5. When they were selling at the price Rs.000 pens a month. (P1 − P0 ) / P0 ∆P / P0 where ∆ denotes the change. (a) Fig. [(P 1 P ) / P ] 100 0 0 [(10 8) / 8] 100 25. 4.

the price elasticity is greater than one (as BC > 0C). 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.1. . A firm is doing it in order to save costs. along the supply curve in panel (a). however. having two major flaws. along the supply curve in panel (b). 4. make beautiful handicrafts. in fig. irrespective of how steep or flat it is. that is. But this is hardly the end of the story. Higher output would require more employment of workers. a narrow point of view. By the same argument.10(b). A traditional typist who is replaced by a computer can learn word processing and possibly land a more paying job. The negative effects of computerisation are present only in the short run. PRODUCER'S EQUILIBRIUM AND THE SUPPLY CURVE 79 range at point B. it is less than one (as BC < 0C).REVENUES. any technical improvement that is labour-saving – is or must be bad for employment. On the other hand. the straight line supply curve passes through the origin. computerisation or mechanisation may. it leads to a greater productivity of workers and higher wages. P0 is the original price. how could it not reduce employment? This is. the point of intersection is the origin. In fig. From the whole economy’s perspective. you can say that the point B is same as the origin.) Thus. Finally. both skilled and unskilled. It turns out that the point elasticity is equal to the horizontal segment BC divided by the quantity supplied 0C. it has a negative effect on employment. the supply curve intersects the x-axis in its positive range. 0C is the quantity supplied and A is the point on the supply curve. First. in panel (C). 4. As the total variable cost curve shifts down. On the other hand. any straight line supply curve passing through the origin.(c) in which there is no point B. Yes. Finally. 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.10(c). for example. so does the marginal cost curve. Also. In all panels. Of course. take away the job of artisans. The traditional thinking is that computerisation – or for that matter. 4. at the time when a machine is replacing a person or many persons. that is. who with their own bare hands. If you replace a person with a machine. CLIP 4-1 Does computerisation reduce employment? This is a sensitive issue for a populous country like India. BC/0C. This means that the supply curve will shift out and more will be produced in the new equilibrium. it has a very short run perspective. and second. the production possibility curve (see Chapter 1) shifts out. implies price elasticity of supply equal to one. That is. expansion of the small-scale 14 The proof of this is beyond our scope. Thus BC = 0C implying e s=1. 14 (Ignore for the moment fig.

In general..80 INTRODUCTORY MICROECONOMICS industries due to computerisation will lead to more employment. . 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. Market supply curve is obtained by horizontally summing up the individual supply curves. The price line facing a competitive firm is horizontal because this firm is a price taker. i. but other category of workers will now find jobs. A perfectly competitive firm maximises profits. but only in the short run.e. The profit-maximising condition. An increase in the rate of the excise duty shifts the supply curve to the left. there are major long-run benefits. In summary. Increasing marginal cost explains the law of supply or why the supply curve is upward sloping. An increase in the price of a substitute good in production shifts the supply curve of the product in question to the left. attains producer’s equilibrium. forms the basis of the supply curve. A cost saving technological progress shifts the marginal cost curve down and hence shifts the supply curve to the right. In the worst case. there may be employment costs of computerisation. when price is equal to the marginal cost. a firm’s profit maximising condition is that marginal revenue is equal to marginal cost. An increase in input prices shifts the marginal cost curve up and hence shifts the supply curve to the left. 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. On the other hand. The price line is also interpreted as the demand curve facing a competitive firm. price is equal to marginal cost. A firm’s supply curve consists of the rising portion of its marginal cost curve.

the individual and the industry supply curves are vertical. irrespective how steep or flat it is.6 4. A straight line supply curve passing through the origin implies price elasticity equal to one. Price elasticity of supply measures the responsiveness of quantity supplied to a change in its own price.2 4.7 4. the marginal costs of production of televisions have gone down. price and quantity sold? What is the relationship between price and marginal revenue for a competitive firm? What is the condition of producer’s 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.12 4. A straight line supply curve which intersects the x-axis in its positive range implies price elasticity of supply less than one.10 What is meant by producer’s equilibrium? What is the relationship between total revenue.9 4.REVENUES.3 4. EXERCISES Section I 4. During the market period.1 4.8 4. PRODUCER'S EQUILIBRIUM l l l l l l AND THE SUPPLY CURVE 81 An increase in the number of firms shifts the market supply curve to the right. A straight line supply curve which intersects the x-axis in its negative range implies price elasticity of supply greater than one.4 4. 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? 4.13 .11 4.5 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. 17.16 4.18 4.17 4. Quantity Sold 1 2 3 4 5 6 7 TR MR AR 4.24 4.26 .19 If a farmer grows rice and wheat. 15.21 4. 5.15 4.22 4. A perfectly competitive firm faces market price equal to Rs. (b) Suppose the market price increases to Rs.25 4. 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 4.82 INTRODUCTORY MICROECONOMICS 4.14 4. Will the new TR curve be flatter or steeper? Complete the following table when each unit of a commodity can be sold at Rs. 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. (a) Derive its total revenue schedule for the range of output from 0 to 10 units.20 4.

27 A firm’s TR schedule is given in the following table.) 7 14 21 28 35 4.34 4.) 1 2 3 4 5 Firm A (kg.29 4.28 4./kg.REVENUES. 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.30 4. How will this affect the supply curve of stainless steel utensils? Because of cyclone in a coastal area. Give two examples where technological progress leads to a shift in the supply curve.) 100 — 135 154 — .) 20 30 — 50 60 Firm C (kg.35 4. What is the product price facing the firm? Output 1 2 3 4 5 TR (Rs.) — 37 40 44 48 Firm B (kg.31 4. PRODUCER'S EQUILIBRIUM AND THE SUPPLY CURVE 83 4.32 4. the sea level. covers a lot of rice fields.33 4.) 45 50 55 — 65 Market (kg. 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.36 Why is AR always equal to MR for a competitive firm? Name three factors that can shift a supply curve.

39 Show that the rising portion of the marginal cost curve is the supply curve of a competitive firm. Rank their price elasticities.37 Complete the above table on quantities of potatoes supplied by the firms and the market.38 The above diagram shows the supply curve of 3 commodities. 2 to Rs. . 3. Section III 4. 4. Draw straight line supply curves with (a) unitary price elasticity and (b) zero price elasticity. (b) Plot the supply curve of each firm and the market supply curve in a single diagram.84 INTRODUCTORY MICROECONOMICS (a) 4. 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.

PRICE DETERMINATION UNDER PERFECT COMPETITION 85 U N I T.I V FORMS OF MARKET AND PRICE DETERMINATION .

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.1 Market Equilibrium and Determination of Price and Quantity 5.86 INTRODUCTORY MICROECONOMICS CHAPTER 5 PRICE DETERMINATION UNDER PERFECT COMPETITION 5.3 Sources of Demand Shifts 5. The question is: which price will prevail in the market? Suppose that. denoted respectively by DD and SS. 5. This issue is addressed in this chapter by pooling together what we have learnt about the demand and supply.1.2 Demand and Supply Shifts 5. in other words. initially. The emphasis is on applications. You will see that there are not many new concepts or definitions to be learnt.1 MARKET EQUILIBRIUM AND DETERMINATION OF PRICE AND QUANTITY Consider fig.5 Anatomy of Famines 5.4 Sources of Supply Shifts 5. These curves respectively tell us how much consumers demand and how much producers supply at different prices.6 Efficiency of the Price Mechanism and Competitive Markets 5. It depicts the market demand and supply curves of a particular product. what points on the demand or the supply curve will be actually chosen in the market place. the price . A number of examples will be provided as we proceed. It forms the core of how the market system works − in particular how an economy’s central problem of “what” is solved through the price mechanism. But they do not tell us what the actual price of the product will be (in principle) or. 5.

consider Table 5. There is excess supply. The term “excess demand” here refers to a particular commodity or service. 21. The price will keep falling as long as there is an excess supply. Excess demand is present at this price also. 5. At this price. the market “rests” at price P0 in the sense that there is no pressure on price to either increase or decrease. equal to AB or Q1D1. Obviously. Consumers want more than what the producers are willing to supply. It will increase. Where will the price finally settle? The answer is again P0. The corresponding demand and supply curves and market equilibrium are shown in fig. Recall that equilibrium means a position of rest. pointing downwards. Alternatively. there is a mismatch. at which there is no excess demand. . which gives the demand and supply schedules of bananas (in a given geographical location and within a given time period).PRICE DETERMINATION UNDER PERFECT COMPETITION 87 in the market for that good is P1.1 Will then the price stay at P1? No. This is different from what is meant by “excess demand” in macroeconomics. 5. the price will keep increasing as long as there is an excess demand. The equilibrium price is Rs. excess demand will create competition among the buyers and push the price up. it is shown at the point E0. The equilibrium quantity exchanged (between consumers and producers) is equal to Q0.000 dozens. it is defined by the equality between quantity demanded and quantity supplied. The equilibrium quantity sold/purchased is 6. In fig. Fig. 5. to P2. say. Indeed. the consumers demand the quantity D1 and the producers supply the quantity Q1.2. Thus price will increase further.1. This is how price and quantity are determined in the market. Finally it will converge to PO. This is indicated by the upward-looking arrow. The situation of zero excess demand and zer o excess supply defines market equilibrium. It is indicated by the arrow. at which there is no excess supply. There is excess demand. Just the opposite happens if initially the price is P3. equal to D3 Q3 which will create competition among the sellers and lower the price. since at this price quantity demanded matches with quantity supplied. The price P0 is 1 called the equilibrium price.1 Market Equilibrium As a numerical example. Here. The quantity demanded (D3) is less than the quantity supplied (Q3).1.

5. not produced at all in India.500 Price of Bananas per dozen (in Rs.500 8. costs are too high for any positive output to be produced. 5. Russia.1 An Example of Demand.000 7. In India and many other countries. These are totally imported. quite possible that a situation such as in fig.500 Quantity Supplied (in dozen) 1. Supply and Equilibrium Quantity Demanded (in dozen) 10.e.000 6. Of course.000 6.3 A Non-Viable Industry Computer memory chips. Put differently.3 occurs: the demand curve and the supply curve do not intersect with each other at any positive quantity.000 5. The price at 2 Fig.000 4.. however.000 8.000 2.88 INTRODUCTORY MICROECONOMICS Table 5. For example. which is not viable in one country.000 4. Britain and France. an industry. can be viable in some other. it is not produced at all.2 Market Equilibrium Corresponding to Table 5. . What does this mean? This means that the product in question will not be produced in the economy. The industry is not economically “viable”. commercial aircraft is such an example.2 It is. 5. commercial aircrafts are produced in America. mother boards and copying machines are other examples. i.) 18 19 20 21 22 23 Fig.1 which any positive amount can be supplied is higher than what the consumers are willing to pay.000 7.

from fig. a rightward shift of the demand curve moves the consumption point from E0 along DD0 to A along DD1.1 and 5.1 applies are.4(a)].2. We see immediately that the equilibrium point shifts from E0 to E1. 5.3 illustrate how the “what” problem of an economy is solved by market mechanism.PRICE DETERMINATION UNDER PERFECT COMPETITION 89 Figs. 5. 5. 5. The analysis of demand and supply curves and the market equilibrium provides the framework to explain such changes. Those for which fig.2 DEMAND AND SUPPLY SHIFTS For any given product in the real world. Some of you must have shopped for fruits and vegetables for your family or for yourself.1 we also know the quantity that will be produced and the price that will be charged in equilibrium. Thus both price and quantity increase. the supply curve or both. A computer for a given configuration sells in your town for. How? Through shifts in the demand curve. as shown by DD1. price and quantity exchanged change from time to time. 5. The new price and quantities are P1 and Q1 respectively. 5. 5. Accordingly. 5. Let the initial demand and supply curves be DD0 and SS0 respectively. The same computer will sell for much less. costs less in the winter than in the summer. for example. Rs.3 applies are not produced. the initial price and quantity are respectively P0 and Q0. six months after.2 Demand Shifts (a) (b) Fig. 5. Apples sell for less in some seasons than in others. say. Starting from the initial situation of no excess demand or supply [at E0 in fig. . It is important to understand the economic process that leads to these changes.4(a). Now let the demand curve shift to the right. Without going into what causes a shift. The same cauliflower. Goods and services for which fig. We already know in Chapters 2 and 4 how various factors cause shifts in these curves. 30. Changes in those factors explain price and quantity changes.000. we first discuss how a demand or a supply shift will affect price and quantity.4 Demand Shifts Turn to fig. Given that a good is produced.

For example. Their net impact on price and quantity will be a combination of 1 and 2 in Table 5. Then the market price may increase or decrease. Why? At the original price P0. the market price will unambiguously increase. 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. In turn. it causes price to increase.2. The new equilibrium point is E1. While there is a change in demand. Hence. hence the new price settles at a higher level. E 0 is the original equilibrium point. there is a change in the quantity supplied. as shown in fig 5.5 (b) Supply Shifts 5. We see that the price decreases and the quantity increases. The new price and quantity are P1 and Q1. Suppose the supply curve shifts to the right to SS1. In panel (a) the original demand It is possible that both demand and supply shifts occur simultaneously. 5. At a higher price they supply more quantity. the decrease in price leads to a downward movement along the demand curve. a leftward shift of the demand curve will lower the equilibrium price and quantity. This explains why the new quantity exchanged is greater.90 INTRODUCTORY MICROECONOMICS This creates an excess demand. and supply curves are denoted again as DD 0 and SS 0. This causes the price to fall and the new price settles at a level that is less than the original price. while the .4(b). Similarly. Since the demand curve remains the same. Likewise. equal to Q0Q'. 5. The opposite happens if both curves shift to the left. an increase in supply causes an excess supply in the market.4 Simultaneous Demand and Supply Shifts (a) Fig. shown in fig.2. producers however operate on the same supply curve. 5. but the quantity exchanged will increase unambiguously. the demand and supply curves both shift to the right. if the demand curve shifts to the right and the supply curve to the left.3 Supply Shifts Now consider supply shifts.5.5 (b) 5.2. and. not a change in supply.

5. 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. by using Table 5. 5.4(b) then applies: both price and quantity fall. especially in towns like Cochin. In some places the land price almost trippled in two years. 3 Think of the market for land. annually. We know from Chapter 2 that. This shifted out the market demand curve for housing in urban Kerala.4(a) applies. undated. 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. foreign exchange worth of 700 to 1. An estimated 16 lakh Keralites were working in the Middle Eastern countries and they brought.4(b) applies. as long as a product is normal. We return now to demand and supply shifts one at a time. the demand curve for it shifts to the right. ▲ . Kottayam. flats etc.3. and. we know that an increase in income shifts the demand curve to the left. 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. examine their causes. T richur.” Touchdown India.3 SOURCES OF DEMAND SHIFTS Recall from Chapter 2 that the market demand curve can shift because of changes in income. It was not because there was a massive industrialisation or an unusual population explosion in these areas. “Highrise Hungama. Fig. The opposite happens if the demand curve shifts to the left and the supply curve to the right.2 Summary of Demand and Supply Shift Effects 1. as the Japanese economy was growing strongly. tastes or size of the market.000 crores of rupees. Both market price and quantity fall.4 Example 5. Therefore. the reason was that a lot of Keralites from these areas moved to the Middle East countries to work and earned substantial income there. Chalakudi and Chavakkad. Fig. 5. various name 4 Air India even operated special flights from Trivandrum to the Middle East to accommodate the increased traffic.1 A Change in Income If it is an inferior good. 5. for a normal good. For a decrease in income fig. This is based on Sonali Mujumdar. Instead.3 They used that income to buy more and better housing at home. ▲ ▲ Suppose that there is an increase in aggregate income in an economy. 5.2. quantity exchanged may increase or decrease.2 Japan in late 1980s and early 1990s. their effects of price and quantity. We analyse each of these in turn. Both price and quantity increase.PRICE DETERMINATION UNDER PERFECT COMPETITION 91 Table 5. Example 5. prices of related goods. 2. an increase (a decrease) in income leads to increases (decreases) in the price and quantity exchanged.1 Market for Real Estate in Kerala. In this period.

15 cents. Applying fig. page 80. Thus. which damaged more than half of its coffee trees. the price of Brazilian coffee in the world market shot up and it remained high in the next few years. we find that the price of sugar as well 5 5. it was 11% higher than it was in 1997.43/pound in 1994. tea being a substitute of coffee. kalara in Oriya and Pavakkai in Tamil.e.jetro.3 Prices of Coffee and Tea in the World Market in the Late 1990s. the prices and quantities sold of these items in Japan soared.20. Brazilian coffee sold for $1. But imagine that medical research shows that eating 100 grams of bitter gourd per day prevents pimples on the face. As a result. As a result. the demand curve for it shifts to the left. Unlike coffee and tea.92 brand products became the outlet for rising income.3. For tea production. 74.46 cents. the market for tea. it is the web site of UK Tea Council. From our analysis of demand shifts in Chapter 2.4(a) applies then.7 Surely it is not a very popular vegetable in your age group. 8th Edition. 80.go.36 cents.2 A Change in the Price of a Related Good in Consumption Take for instance. Suppose the price of tea goes up. Suppose the price of coffee rises for some reason. http://www. Fig. 1994. 1997 and 1998. namely. It remained high for the next four years ($1. However. In the New York wholesale market.08 per pound for the years 1993. the price of tea in the world market also jumped up (while the production of tea was still growing). 1995. The Data sources are the following.teacouncil. “The Japanese Consumer: From Boom to Reality. we know that.46. 5. How does it affect the sugar market? From Chapter 2 again. it more than doubled. Example 5. This will definitely generate a 6 7 See William Baumol and Alan Blinder. as the price of a substitute good in consumption rises. 83. For example. 1997 and 1998 respectively). Economics: Principles and Policy. http://www.” 1994.co. Also see JETRO (Japan External Trade Organization). the price of a given product rises and its quantity exchanged increases. the world production of tea in 1997 was 2% higher than that in 1996. For coffee and tea prices. 1996. the wholesale tea prices. and. International Financial Statistics Yearbook 2000. as the price of a complementary good increases.6 5.jp/it/e/pub.uk. were 84. it is International Monetary Fund. the demand curve for tea will shift to the right. it was hit by two severe frosts. i. In 1994. 1996. there was an increase in demand for Levi’s jeans and Nike shoes. Harcourt College Publishers. $1.3 A Change in Tastes Think about the market for bitter gourd.22 in 1995.5 INTRODUCTORY MICROECONOMICS ▲ as its quantity will fall. $1. Brazil is a major producer in the world coffee market. compared to 66.3. With a lag of two years. as quoted in the London auction market. This can be interpreted as a delayed effect of an increase in the price of coffee on demand for tea. 5. in 1998. $1. This is called karela in Hindi.08 and $1. the price of a given product and its quantity exchanged both decrease. Observe that the tea price went up particularly in 1997 and 1998. Hence.67 and $1. sugar consumption is complementary to tea.4(b). During the same time period.20 cents. ▲ ▲ . The price of tea rises and so does the quantity of tea exchanged.58 cents in 1993. 2000.

which pushed up the land price in Delhi. Many airlines had to reduce their scales of operation drastically. whereas a decrease in the population will do the opposite. 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. Consider air travel. The market demand curve will shift out. especially from Hong Kong. Most of those who came to Canada settled in Vancouver. Shortly after that day. on the average.8 Many of you will start to eat more bitter gourd than before. in 1995. This can be interpreted as an increase in market size for land in Delhi. These things did happen. This was primarily due to the huge migration of people from Asian countries. ▲ ▲ change in your food habits.4 A Change in Market Size By now you should know immediately how this affects price and quantity. Example 5. After the terrorist attacks in America on September 11. Thus. there was a major decline in the ticket price of air travel within America and a large decrease in the number of passengers. The source of this material is David Ley and Judith Tutchener. They were.2 lakh Canadian dollars. many people became afraid of flying.08 lakh Canadian dollars. Vancouver Centre of Excellence.9 Their demand for housing was the main factor behind the house price surge there during the period 1990-1995.3.PRICE DETERMINATION UNDER PERFECT COMPETITION 93 Example 5. there was a substantial increase in land price in Delhi. We can use fig. The price of air tickets would fall and less number of people would travel. Overall. it means a change in demand due to reasons other than price or income changes. on the average. Likewise.4(a). wealthy. March 1999. during 1990-1995. 5.10 ▲ Recall that a change in taste does not only include a change in taste in one’s mouth.” Research on Immigration and Integration in the Metropolis Working Paper Series. It was because of large scale migration of people from Punjab to Delhi following disturbances in Punjab in the mid 1980s. by and large. in 1990 to nearly 3. “Immigration and Metropolitan House Prices in Canada. migration from overseas contributed 79% to the net population growth of Vancouver. 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.6 House Price Rise in Vancouver. Canada. and deduce that price of bitter gourd as well as the total quantity produced and consumed of it will increase. Compared to 1970s. Example 5. 2001. 5. a decline in liking for a product will cause opposite changes.5 Land Price Increase in Delhi in 1980s. This can be thought of as an adverse change in tastes due to fear of flying. a favourable (an unfavourable) change in taste will cause product price and quantity exchanged to increase (decrease). which would shift the demand curve for air travel to the left. ▲ ▲ ▲ . quantity.4 Market for Air Travel.

8 Personal Computers. Its speed (similar to the speed of brain) is given in a MHz rating. Therefore. 7.1 Technological Progress It shifts the supply curve to the right. A year later in 2001. 5.9 Internet Café Rates in India. In the year 2000.7 was about a decrease in input price due to technological progress. Thus. The case of CPU was discussed in Example 5. the product price decreases and the quantity rises or the price increases and the quantity falls according as an input price decreases or increases. ▲ ▲ ▲ ▲ . Indeed. technological progress leads to a fall in price and an increase in quantity exchanged. In 2001. A 15" colour monitor used to cost around Rs. 14. after being introduced in the market. changes in excise taxes or changes in the prices of related goods in production cause shifts in a firm’s supply curve − and hence shifts in the market supply curve. we see the price of a CPU of a given speed going down rapidly over time. These cafes have sprawled in many cities.2 Change in Input Prices From Chapter 4 we know that the supply curve shifts to the right or left. As a result. in 2000. sometimes less. a CPU of a given speed becomes almost obsolete in a matter of 6 to 7 years. all over India. 9.8 the product price decreases because of decrease in input prices.e.5 square inches in size only. it came down to about Rs. For instance. Fig.400 in 2000. Note carefully that Example 5. big and small.000. my desk-top computer had a 550 MHz CPU in it. About 1. in Delhi an hourly 11 For example. changes in input prices. 5. a change in the number of firms shifts the market supply curve without affecting the individual supply curves. a 550 MHz CPU cost around Rs. Example 5. Moreover. the CPU is placed inside a computer. It is a common observation now a days that the price of a PC system (the computer.4 SOURCES OF SUPPLY SHIFTS In Chapter 4 we learnt that technological progress.4. 8. Other components of a computer system are becoming cheaper also. the production of CPU has seen phenomenal technological progress. the Central Processing Unit. Example 5. at the time of writing this book.7 Micro-computer CPUs.5(a) and (b).5(a) applies. the brain of any micro-computer is its CPU. it was selling at around Rs. inputs) that go into making a PC are becoming increasingly cheaper.4.7.000. 5. It is because the components (i. ▲ This is a prime example of technological progress. as an input price decreases or increases. the monitor and the printer) of given configurations goes down rapidly over time. Example 5.000. As you might know. 5.11 Over the last few decades. the technological progress is so rapid that.94 INTRODUCTORY MICROECONOMICS 5. whereas in Example 5. in view of figs.

11 Mobile Phone Rates. Pond’s talc and Lakme make-up products. 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. there were initially two companies: AirTel and Essar.e. Example 5. HLL reduced prices across a variety of brands including Clinic and Sunsilk shampoos. less competition does the opposite. (HLL). price falls and quantity rises or price rises and quantity falls. In 2002. Pond’s skin creams. From fig. the price of computers came down. as the excise duty rate increases (decreases).4. i. Thus. went down. 50. 15 in many such cafes. 5.PRICE DETERMINATION UNDER PERFECT COMPETITION rate for internet “surfing” was no less than Rs.3 Change in Excise In Chapter 4. 5. from figs. which are cheaper and through which the connection can be kept uninterrupted for 24 hours a day.10 Cosmetics Toiletories in 2002.4. 5.5(a) and (b). 15 per minute. and In the union budget of 2002-2003. Example 5. as there is more or less competition in terms of the number of firms. 5. the internet access charges to these cafes by ISPs (Internet Service Providers) such as VSNL (Videsh Sanchar Nigam Limited). As soon as it happened. By the end of 2002. First. For example.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. the market supply curve can if the number of suppliers in the market changes. in connecting to the ISPs. In Delhi. 5. it came down to an average Rs.5 Number of Firms Even when the individual supply curve does not shift. Second. we saw that an increase (decrease) in the excise duty rates shifts the supply curve to the left (right). it follows that the price of the product will increase (decrease) and quantity transacted will decrease (increase). ▲ 12 This rates were found from the author’s own survey.4. Applying fig.5 then.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. 95 5. there . 12 This is because of reduction in input prices. no less than Rs. was completely removed. Satyam etc. ▲ ▲ ▲ Mobile phones came to the four major cities of India in the mid 1990s. the special excise duty on cosmetics and toiletories. Godrej and Proctor and Gamble (P & G) reduced prices in this category of products. Third. A decrease in the number of firms.. cable lines could be used. 16% earlier. instead of phone lines. major companies like Hindustan Livers Ltd. The charges for outgoing and incoming calls were quite high.

▲ In October -November of 1998.. a large portion of a region’s population Although the mobile phone market has only a few number of firms. which is a contributing factor in the decline of mobile phone charges. Example 5. flood etc. MTNL's Dolphin and Tata-Birla -AT & T's Idea.5 ANATOMY OF FAMINES: AN APPLICATION OF THE DEMANDSUPPLY ANALYSIS The reach of demand-supply analysis is quite far and deep. tea or computers.13 Epidemics typically result from large scale starvation. Incoming calls in some schemes are even free. the total production of the staple food is severely affected. For instance. Hutchison's Hutch (which acquired Essar). we apply it to understand how famines occur. In this section. Not only it explains what happens in the market for products like coffee. The mobile phone rates have come down drastically. The reason behind this unprecedented onion price rise was heavy rains and flooding in the onion growing areas in India. For reasons like natural calamities and unfavourable weather over critical months. As a result. an estimated 16 lakh people died. 5. it can shed light on very complex socio-economic issues. famine can be seen as a massive incidence of starvation. Hence. not many as in a perfectly competitive market.96 were four companies : Bharati's AirTel. We can define total availability of a product as the amount produced plus the amount stored in government and private warehouses. analytically. consumed by most households. which caused a drastic decrease in supply of onions to the market in that year. Onion being a very common vegetable. Therefore. it is the entry of new firms. which drastically limits the total availability. A specific example of this and its effect on price is given below. natural disasters such as cyclone. it became a very politically sensitive issue. The standard view is that it is primarily a production or “total availability” problem. In turn.6 Other Factors Factors like weather. one of the worst famines of the 20th century. starvation is reflected mostly in the staple food of the region. variation in agricultural output in India from one year to the next is dependent partly on how good the monsoons are. the onion price in India increased 6 to 10 times from its usual price.4. can also affect the supply of a product. 13 In the Bengal Famine of 1943 for example.12 (In)Famous Onion Price Increase in 1998. which are results of Nature’s play. ▲ ▲ . INTRODUCTORY MICROECONOMICS 5. the question is how a large section of a region’s population cannot afford to buy the minimum amount of the staple food for survival. A famine is characterised by widespread death due to starvation and epidemics.

but such a price cannot prevail in equilibrium and hence is irrelevant. the FAD theory is illustrated in terms of the demandsupply analysis. curve intersects the price axis. DD M as the horizontal summation of the three individual demand curves. From the supply side. which depicts the individual and market demand curves for rice as well as the market supply curve of rice. potential amount available for consumption. It is hoped that some of you will be inspired. decide to study economics further in college and eventually bag Nobel prizes for India. all families are able to buy rice. If the market price is p2 the A. with FAD standing for food availability decline.14 See Clip 5-1 for a short bio-sketch of Amartya Sen. We can interpret the A-type as the poorest. but the B-type or the C-type family can. Appendix 3 illustrates his theory in terms of the demand-supply analysis.. A. let the total available amount initially be M0. the only Nobel laureate in economics in Asia thus far.6. It is drawn vertical to represent that. This is not true for the B-type or the C-type family. Poverty and Famines: An Essay on Entitlement and Deprivation. 14 Note that when the price of rice is p1. Professor Amartya Sen of India. the market demand curve is obtained by horizontally summing the demand curves of all families. The B-type family’s demand curve lies to right of that of the A-type and the C-type family’s demand curve lies to right of that of the B-type. this price is above the point at which the DDA. A. B and C respectively buy 15 16 17 The material on FAD theory and Sen’s own theory is based on Sen. the “richest”. Panel (d) depicts the market demand curve. after the harvest. mimeo. calls this the FAD theory. At this price.1 The FAD Theory Let the staple food be called rice. B and C. Indian Statistical Institute. its quantity 16 demanded is C2. the A-type family cannot afford to buy any rice at all. The former demands the amount B1. (b) and (c) graph their demand curves respectively. The demand-supply version of these theories is the author’s own copyrighted work. Oxford University Press. But this will not change the analysis. based on “Theories of Famine: An Exposition”.PRICE DETERMINATION UNDER PERFECT COMPETITION 97 does not get the minimum amount for survival and there is a large-scale starvation. 1981. the A-type family’s quantity demanded is zero. If there are two or more families of any given type. in the market. For those who are interested. The types A. 5.5. In what follows. Hence. Professor Sen’s own theory of famines is different.K. We can instead draw a standard upward sloping supply curve.17 The equilibrium price is then p0. As shown. If the price of rice is p3 or higher no one can buy rice. and the latter the amount C1. But it is not a major assumption at all. Let us say that there are three families. April 2002. the B-type as the next poorest and the C-type. 15 5. Turn to fig. . this is the total. The resulting curve will look similar to DDM. The panels (a). This graph assumes that there is one family of each type.and B-type families cannot buy rice but the C-type can.

at this time of writing. over definitions of welfare and poverty indices. say. and. Oxford University. particularly welfare economics. one in which there is no starvation or famine. The equilibrium price is higher. Notice that at this price. Now suppose that. This situation can be interpreted as “normal”. Since then he has held faculty positions in various prestigious institutions at home and abroad such as Delhi School of Economics. 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. He has received more than forty honorary doctorates from major universities around the world. Currently. to empirical studies of famine. equal to M2. London School of Economics and Harvard University.g. Whether exactly two types Fig. his research has ranged over many areas of economics.6 FAD Theory of Famines . and C0. there is less amount available. and the Bharat Ratna award. We can interpret this as a situation of famine or massive starvation. 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. he is the Master of Trinity College at Cambridge University. but the other types can. from Cambridge University in 1959. equal to M1.” A0. He studied in Calcutta University and later got his Ph. because of a bad monsoon. His contributions range from axiomatic theory of social choice. which is the highest civilian award in India. the poorest cannot afford to buy any rice. If. B0.98 INTRODUCTORY MICROECONOMICS CLIP 5-1 By now Professor Amartya Sen is a household name in India. equal to p1. instead. In awarding him the Nobel prize in 1998.D. the total available amount were much less compared to the initial situation. e. He was born in Santiniketan in 1933. 5. He has published numerous books and articles. for some reason. 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. and philosophy.

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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 everyone’s 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

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.

2 5. the price rises but the effect on quantity exchanged is unclear. This causes starvation.102 INTRODUCTORY MICROECONOMICS l 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. An increase in the rate of excise duty leads to a higher price and less quantity being exchanged of a particular product. Define market equilibrium. A price control system includes a rationing scheme since the quantity demanded at the control price exceeds the quantity supplied of it.4 Give the meaning of excess demand for a product. which is purchased by the government.3 5. the effect on price is ambiguous but the equilibrium quantity exchanged increases (decreases). the price of foodgrains increases. An increase in an input price leads to a higher price and less quantity being sold. 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 cost reducing technological progress leads to a lower price and more quantity being sold. It also leads to black marketing. A favourable (an unfavourable) taste shift leads to a higher (a lower) price and quantity transacted.1 5. such that families in the lower end of wealth and income can no longer afford to buy it. Give the meaning of equilibrium price. as the available quantity of foodgrains falls. Give the meaning of excess supply of a product. More competition in an industry leads to a lower price and a higher quantity exchanged. A price support system leads to a surplus of output. The demand-supply equilibrium in a free market can be seen as co-ordination between consumers and producers. EXERCISES Section I 5. If both the demand and supply curves shift to the right (left). . 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. According to the FAD theory of famines. If the demand curve shifts to the right and the supply curve to the left.

22 .21 5.18 Show the determination of market equilibrium with the help of demand and supply schedules and a diagram.8 5.20 5.17 5.14 5.16 5. because of an increase in the price of cotton. At the same time. 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 5.9 5.13 5.15 For a non-viable industry.7 5. 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. the supply of jeans decreases.5 5. 5.PRICE DETERMINATION UNDER PERFECT COMPETITION 103 5.6 5.10 5. 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.19 5. Suppose the demand for jeans increases.” Comment.12 5.11 5. Analyse how will it affect the market price of wheat.

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.30 5. the Supreme Court of India banned smoking in public places. which means that it can sell its product in other member countries like India.26 5.28 5. Given one example each of direct intervention and indirect intervention in the market mechanism.104 INTRODUCTORY MICROECONOMICS 5. It has recently become a member of WTO. demand rises. 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. ceteris paribus.33 Mrs. (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. (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.23 5. Defend or refute. How will it affect India’s total expenditure on telephone instruments? In the union budget for year 2002-2003.24 5.25 5. .32 5. how will it affect the market price of tea? Suppose the price controls on sugar are lifted. Consider their effects on the market for new cars. How would it affect the price of drugs? China is a big manufacturer of telephone instruments. All other things remaining unchanged.27 5. Ramgopal says that economists say inconsistent things: as price falls. 1 per kg (this is a fact). to Rs.29 5. 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. 2 per kg. the excise duty on tea was reduced from Rs. Describe the FAD theory of famines. will it affect the price and quantity consumed of sugar? Section III 5. but as demand rises. Suppose that it does export a large number of telephone instruments to India. price rises. How.

They go under the name of imperfect competition or imperfectly competitive market. i. . There are other market structures. Having already analysed the implications of (a) and (b) under perfect competition.e. given that the objective of a firm is to maximise profits. which are not perfectly competitive. 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. monopolistic competition and oligopoly. There are three broad forms of imperfectly competitive markets: monopoly. In this chapter.2 Monopoly 6. In this chapter we study market structures as such. In Chapter 4 we saw how (a) and (b) lead to the supply curve.. and. perfect competition in the long run. In Chapter 5 we studied the interaction between supply and demand curves.OTHER FORMS OF MARKET STRUCTURE 105 CHAPTER 6 OF OTHER FORMS MARKET STRUCTURE • • • 6. learnt how the price/market mechanism works. (b) the product is homogeneous and (c) there is free entry and exit of firms in the long run.1 Perfect Competition in the Long Run: Free Entry and Exit 6. we analyse the first two. we begin by analysing the implications of feature (c).3 Monopolistic Competition The notion of market structure was introduced in Chapter 4.

Similarly. The exit process will continue till there are no losses. losses are called abnormal losses. Moreover. the price at which the abnormal profit is zero. P1. . in turn. The pattern of returns to scale − that is. which will lower price and profits. How does producer’s 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. if. a positive profit is sometimes referred to as abnormal profit. that is. which. Moreover. In economics.106 INTRODUCTORY MICROECONOMICS 6. Suppose that the market price of the product is P1. This is the break-even price. 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. The economic logic behind it is also parallel to that in the short run. Recall from Chapter 3 that there are no fixed costs in the long run. a firm would experience increasing returns to scale. the price is low enough such that firms are incurring losses. How far will this continue? It will happen till there are no abnormal profits. negative profits. 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 producer’s excess earning over her opportunity cost. The price will rise. suppose that the price. initially. Note that profit being zero is equivalent to P = LMC . both the Long run Average Cost (LAC) and the Long run Marginal Cost (LMC) curve are U-shaped. driving down the market price and profits. Together with the profit maximising condition P = LMC.1 PERFECT COMPETITION IN THE LONG RUN: FREE ENTRY AND EXIT Before analysing the implications of free entry and exit. It then follows that free entry and exit imply zero profit in equilibrium. Profit is maximised when P = LMC. This will shift the market supply curve to the right. firms are making positive profits. We are now ready to examine the effects of free entry and exit. abnormal profits will attract many new firms to the industry.) In this situation. 1. initially at low levels of output. followed by constant returns to scale and diminishing returns to scale − implies the U-shape of LAC curve. (Likewise. at the profitmaximising level of output. This will tend to shift the market supply curve to the left. and the firms are producing at the point where the price line intersects the LMC curve. the long-run competitive equilibrium is then defined by P = LMC = LAC. implies the U-shape of LMC curve. free exit means that some existing firms will start to quit the industry. is high enough such that. Losses will be less. we discuss a couple of things. 2. Another way to look at it is that there will be more competition.

1(b) depicts the long-run market supply curve (with the number of firms being equal to its equilibrium value) and the demand curve. See Exercise 6.e. transmission and distribution of electricity were in the hands of State Electricity Boards (SEBs). 6. you hear many people use the term “xeroxing” (a) (b) Fig. the generation. To take another instance. before liberalisation in the power sector got underway in the 1990s. In India. 6.2 MONOPOLY Some of you must have heard this term before. This is illustrated in fig.1 Firm and Market Equilibrium in the Long Run . There is an important property associated with a perfectly competitive market in the long run equilibrium. i. it is not possible to see what this number is in this diagram. That is. “Mono” means “one”.. Fig. production occurs at the most efficient scale. firms are in equilibrium (i.1. but it is not that large so as to incur the problems associated with decreasing returns to scale.OTHER FORMS OF MARKET STRUCTURE 107 That is. 6. At this level of output. as price equals average cost.47 for a numerical solution. Implicit in this panel is that there is an equilibrium number of firms. they are maximising profits) and there is no entry or exit. at the long run equilibrium. The firm’s scale of operation is large enough such that the benefits of increasing returns to scale have been realised. This is defined in the context of a given geographical location or space. The total equilibrium quantity produced and exchanged is QL . both the marginal cost and the average cost are equal to the price pL.where the LAC is at the minimum.e. Abnormal profits are zero. “poly” means “seller” and thus “monopoly” means one seller. Market equilibrium occurs at price pL. Panel (a) shows that a firm produces the output qL. However. The SEBs were monopolies in the respective states. not too many or too few. 6. the firm produces at a level (qL). which is consistent with profits being zero.

The most important patent legislation in India is the Indian Patent Act of 1970. and get a fairly quick decision. to a country like Ghana. a major amendment to the Patent Act of 1970 was done in 1999. patents are being protected more aggressively than before. Barring a few exceptions. During the patent life the patent holder can sell license to other firms for using its technology (legally). and many poor people will be denied access to these drugs. by which both product and process patents are allowable in the food and drugs sector. This allowed Indian drug companies to produce drugs invented in the developed countries and sell them in less developed countries. There is a fear in India that. named Combivir. This is because research and development.wto.108 INTRODUCTORY MICROECONOMICS CLIP 6. is an example. is patentable. the license is sold to firms who operate in markets other than where the patent holder operates. The enforcement of patent law is also strict in developed countries. because of our being a member of WTO. As a result. http://www. discoveries and inventions have not been a focus of activities by firms. However. we generally import technology from abroad. particularly in the drug sector. e. who may be using its technology without a license. Typically. After the hearing of arguments by both companies. the patent law and its enforcement are rather passive. an Indian drug company.org and read many articles on these issues. We recommend you to visit WTO’s website. . To continue our account of Cipla selling Combivir in Ghana. In India. A patent holder can take to court some other firm. Cipla has supplied antiAIDS drugs. It provided that any invention of a new product or a process of production. Recently however. Once multinational companies start to sell them. as an obligation of being a member of WTO (World Trade Organisation). a careful and rational thinking might suggest just the opposite.. the government of Ghana in 2000 rejected Cipla’s application to market this drug in Ghana. But it explicitly did not allow product patents in the drug and food sector. Cipla. In India.1 Patent Laws Most developed countries have comprehensive patent laws. the drug prices are going to skyrocket. in a different country. which is useful and not obvious. we are forced to honour patent protection.g. India and other countries had to revamp their patent laws. 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. For a long time. In general. 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. Indian companies will no longer be able to sell many essential drugs at affordable prices.

Ricoh. which discovered the plain-paper photocopying machine in 1959. This period is called patent life. A monopoly market structure emerges because of any of the following reasons. in the world market that produce photocopying machines. till 2002. Another example is a drug company called Eli Lilly. it is currently 17 years.S. in the U. Many fax machines also have copying capability. 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. This is called a cartel. Canon. There is little competition.2 However. monopoly arises because of granting patent certificate or what is called patent rights. Actually. they can apply to their government for a patent. They are valid only for a certain number of years (after which other firms can freely copy the technology). This patent is supposed to expire in 2003. (a) The government gives license to only one company for producing a product or providing a service in a given locality or space. It is implicit that there are no close substitutes to the monopoly’s product or service available in the market. A monopoly is the opposite of the per fectly competitive market structure: there is just one firm/seller instead of many. See Clip 6-1 on patent laws. Mita. In other words. fir ms retain their individual identity but they coordinate their outputs and pricing policy so as to act as if it is a monopoly.g. The OPEC (Organisation of Petroleum Exporting Countries) in the 1970s is an example of a cartel that led to virtual monopoly in the 2 Plain-paper photocopy machine has been regarded as the most successful commercial product in history. Royal.) Throughout the 1960s it was the only company that manufactured and sold plain-paper photocopying machines. Panasonic. VSNL (Videsh Sanchar Nigam Limited) had monopoly in India in providing international telephony service. Xerox is an American company. besides Xerox. Now there are many well-known companies. It is also implicit that there is no free entry (otherwise. In Australia it is 20 years. The case of Xerox is an example.OTHER FORMS OF MARKET STRUCTURE 109 to mean the use of a photocopying machine. In most developed countries the patent life varies between 15 to 20 years. . Sharp and Toshiba.. (c) Sometimes. As a reward for their risk and investment in research. It obtained patent on it. e. (The concept of patent will be explained shortly. patents are not granted for ever. more than one firm can operate in the industry). which has a patent on a very widely used antidepressant called Prozac. (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.1 This is an example of a private monopoly. For instance.

in the tea industry. Algeria in 1969 and Nigeria in 1971. America was and still is. United Arab Emirates in 1967. The oil shortage of 1970s motivated many other countries to explore oil. there are other countries which are major producers of oil. But a monopoly firm faces the entire market.110 INTRODUCTORY MICROECONOMICS world market for oil. total cost. . as output increases. Brooke Bond and Lipton merged and subsequently they merged with Hindustan Lever. equals total revenue minus total cost. India also produces oil and is an importer. None of this is true for a monopoly since it is the only producer by definition.g. Average and Marginal Revenues The objective of a monopolist is to maximise its total profit..2. This is the most important difference of a monopoly firm from a perfectly competitive firm. in the import-export market. It has market power and it is a price-maker so-to-speak. marginal cost etc. In case of the latter. Mexico. merger and acquisition. See Clip 6-2 for a brief history of the OPEC and the world oil market. another large tea firm. so as to manipulate the price of petrol in the world market. e. But its consumption is even greater and thus it is an importer of oil. we already know that. namely. and their general shapes are also the same as for a competitive firm. The cost structure facing a monopolist is similar to that of a competitive firm. average cost. by definition. But the revenue structure facing the monopolist is quite different. Recall that a perfectly competitive firm is very small compared to the market.. In the early 1990s. It came into existence in 1960. who were major exporters of oil and who used to be importers of oil earlier. 3 There are other reasons for monopoly or near-monopoly also. e. Hence. the price remains unchanged. For example.. Saudi Arabia and Venezuela. a big producer of oil.1 Total. By mid 1980s there were other countries. It implies that the way total revenue changes as output changes is different from what happens to a perfectly competitive firm.3 6. OPEC in the 1970s can be interpreted as a monopoly. It does not have any market power and thus it is a price-taker. hence faces the market demand curve.) The aim of the OPEC countries is to set production quotas. We have the same concepts.g. Kuwait. Qatar joined it in 1961. In the 1970s when the first oil price shock overtook the world economy. followed by Indonesia and Libya in 1962. Hence. The Netherlands and Russia. OPEC consisted of the above-mentioned countries. (Currently there are two other countries in OPEC. 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. Ecuador and Gabon. It left out Tata. Besides the OPEC. which. Iraq.

Also recall from Chapter 4 the concept of Marginal Revenue (MR). AR = TR/output. cannot not just charge any price at its sweet will.1 A Demand Schedule Price (in Rs. the market demand schedule is as given in Table 6. 7. the market demand curve is a constraint facing a monopoly firm. believe.OTHER FORMS OF MARKET STRUCTURE 111 willing to pay along the demand curve. AR = price × output/ output = price. It could have. we get the Total Revenue (TR). This is Table 6. she will be able to sell only less than 4 units. TR/output = 0/0. by definition. The reason is as follows. by multiplying output by price. starting with output equal to 0 (and corresponding price equal to Rs. AR is equal to price. This is true except when output is zero. as long as she wants to sell 4 units.) 1 3 5 7 9 11 13 15 Quantity Demanded (units) 7 6 5 4 3 2 1 0 shown in column (4). there were absolutely no substitutes available. since. 4 5 Hence. But for most products substitutes are available. which is not defined. This point must be understood very clearly. The last column gives the MR schedule. 7. These two columns represent the same demand schedule as in Table 6. i. Now. Put differently. that is. This is done along the first two columns in Table 6. a monopolist despite having market power. Similarly.e. it can be argued that if the monopolist wants to produce and sell 5 units. Since the monopolist faces this demand schedule it means that if she wants to sell 4 units for example. there is no reason to sell at any price less than Rs. At zero output. she can sell them all by charging Rs. which are given in column (3). the price charged will be Rs. 7. 7 each − because along the market demand curve 4 units are demanded at the price equal to Rs. Suppose. 7. 15). Moreover.2. If she charges any price higher than Rs. only if the demand curve were totally vertical. and so on. Dividing TR by output gives average revenue. she (the monopolist) must charge price equal to Rs.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. The monopolist has to take this into account. unlike what many. defined as the addition to the total revenue from one extra unit sold.1. especially non-economists.. TR being equal to price × output. AR. 5. .5 Thus the entries in column (4) are same as those in column (2).1. Therefore.

Since AR = price.112 INTRODUCTORY MICROECONOMICS We note the following properties of the three revenue concepts. Thus the shape of the TR curve facing a monopoly firm is quite different from that facing a competitive firm. The TR curve is inverse U-shaped as TR initially increases and then decreases with output. Therefore. certain level of output it becomes negative. 6. 1. This is because MR is initially positive and then negative.2.2 The TR. 5. MR decreases with the output. and the AR and MR curves corresponding to Table 6. if we graph TR against output (i. it is always same as the demand curve facing the firm. if output is measured on a continuous scale. 2.) 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 4.2 .) TR (Rs. it means that. TR reaches maximum when MR = 0.e. TR increases or decreases as MR is positive or negative. 3. Except for the first unit. if “average” is falling (rising). MR < AR. Moreover. (a) (b) Fig. “marginal” is less (greater) than the “average”. Panels (a) and (b) of fig.) MR (Rs.2 respectively graph the TR curve. that is.) AR (Rs. 6. This follows from the relationship between “average” and “marginal” discussed in Chapter 3. the TR curve). it rises initially and then falls. AR and MR under Monopoly Output Price (Rs. if we wish to graph the AR curve. AR and MR Curves corresponding to Table 6. Initially it is positive and after a Table 6.2 TR. at all other levels of output. TR first increases with output and then it decreases.

3 Monopoly Versus Perfect Competition These are the following general and important features of monopoly in comparison to perfect competition. MR will exceed MC. That is. 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. On the other hand.3 depicts a smooth hypothetical TR curve and the associated AR and MR curves.2Profit-Maximising Rule A full analysis of a monopoly’s profit maximisation or producer’s equilibrium is beyond our scope here.OTHER FORMS OF MARKET STRUCTURE 113 Fig. the savings in cost will be greater than the revenues lost and hence profits will be higher. Since. Shifts in the Demand Curve (AR) or in the MC curve do affect a monopolist’s output and price. however. MC will be very high and MR very low (possibly negative). where MR = MC. these are respectively equal to additional revenue and additional cost. This means that. 6. profit is maximum at the level of output. This is indeed a very general condition of profit maximisation by a firm.3 Smooth TR. (a) The condition (A) is quite intuitive. In monopoly. Hence there is no supply curve as such under monopoly. which will be more than the additional cost involved in increasing the output. This does not mean however that demand and supply forces do not interact. (It was noted in Chapter 4 also. But we can state its condition: MR = MC. Thus the firm will obtain more profits if it increases its output. a monopolist maximises profit by selecting the level of output at which MR = MC. (A) . AR and MR Curves 6. They do. As you can notice. as long as MR > MC. by definition. TR reaches its maximum when MR = 0. (b) Fig.) Recall that for a competitive firm MR = P and thus the condition P = MC is a special case of the general condition MR = MC. the fir m decides output and price. if the firm reduces output. a marginal increase in output will fetch additional revenues. Therefore. 6. At very low level output. 1. 6.2. There is no question of the optimal level of monopoly output at different prices.2. at a very large level of output.

Hence. in a sense. 6. For example. By merging. This. will induce the monopoly However. . charges “too high a price” for its product. It means that a monopoly. one firm may have excellent technical manpower but may not have good marketing skills. there is no entry and exit. 1. while price is equal to marginal cost in perfect competition. which drives profits to zero in the long run. Suppose that initially there are two firms in an industry and both are somewhat inefficient. there is little analytical difference between short run and long run in terms of output and price determination. They realise. It is the basis of negative sentiments against a monopolist. We already know that. along a given demand curve. For instance.114 INTRODUCTORY MICROECONOMICS 2. by itself. But the point is that as long as there is monopoly. that if they merge with each other − and thereby become a monopoly − they can reduce their costs. in monopoly. the resulting monopoly firm’s MC curve will be at a lower level and thus it will be a more efficient firm. if the monopoly is present. In perfect competition there is a major difference between short run and long run. whereas the other may not have good technical manpower but possesses superior marketing knowledge. there is free entry and exit.4 MERITS OF MONOPOLY But before we rush to this conclusion we should note some good things about the monopoly too. in the first place.2. by virtue of a patent. Moreover. P > MR and it selects an output level where MR = MC. In summary. it follows that. for a monopoly. the price exceeds marginal cost under monopoly. the patent eventually expires and other firms use the same technology and there is competition. compared to perfect competition. essentially. however. we can then say that the monopolist produces less and charges a higher price. In contrast. Not only are cost curves different (because there are no fixed costs in the long run).6 3. 6 The last point summarises what is “wrong” with a monopoly market structure. it is quite possible – and likely – that over a long period the monopolist loses its monopoly power. by definition. Now we come to the most important behavioural difference between monopoly and perfect competition. 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. less is sold − and therefore less is produced − under monopoly than under perfect competition. the monopoly price being higher than the competitive price. 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. that is. These two relations imply that P > MC. there is not much analytical difference between short run and long run.

The objective of this legislation is to permit mergers.. this is indeed the essence behind granting patents. . acquisitions and business practices that have strong ef ficiency ef fects and prevent those. Products like toothpaste. Neem. We already know that this is a bad thing. which is less. Babool. these activities are very risky propositions. i. This is a good thing about monopoly. Loreal. 6. Cibaca. Acquafresh. which is greater than when both firms were competing with each other. each firm produces a brand or variety (of the same product) that is unique.OTHER FORMS OF MARKET STRUCTURE 115 to charge a price. Promise and Vicco Bajradanti. Pepsodent.e. the MRTP Act of 1969 is the land-mark anti-trust legislation. Meswak. The varieties produced are very close substitutes of one another. Its features are the following. different from what any other firm produces. For example. at the point of writing this book. and produce a quantity. Anchor.7 2. which are meant to create or enhance market power accompanied by little efficiency gains.3 MONOPOLISTIC COMPETITION This is an interesting market structure. soap and lipstick are prominent examples.g.. (c) there is product differentiation. 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. Maybelline. (b) implies that firms earn zero abnormal profits in the In India. Amar. Colgate. If ef ficiency gains are suf ficiently strong. there is a trade-off between efficiency and market power. Hence. Close-Up. (a) There are a large number of sellers and buyers. On the other hand.8 Features (a) and (b) are competitive features. (a) states that each firm is small relative to the market. in which both competitive and monopoly elements are present. there are 7 brands of lipstick available in the Indian market: Avon. Forhans. Many countries including India have the so-called anti-trust legislations to deal with this issue. Elle. Lakme. then a monopoly serves the society better and hence is preferable. Revlon and Tips & Toes. That is. (b) There is free entry and exit in the long run. Moreover. In reality. There are many more brands of toothpaste. e. the resulting monopoly will be in a position to exercise greater market power and charge the monopoly price. Another major benefit from granting monopoly is that monopoly power and profits provide incentives for inventions and innovations. Often times they materialise from individual efforts and persistence. 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.

As said in the beginning of this chapter. Together with the profit maximising condition MR = LMC we can then compactly write the long-run equilibrium conditions in monopolistic competition as MR = LMC.g. Moreover. Analytically. since there is no competition. in terms of decision-making. it charges a price.. which is useful for the consumers. In this sense. which exceeds marginal cost. This is persuasive advertisement and its purpose is to lure away consumers from other brands. compared to other brands. there is one aspect of it. 9 Although the features of monopolistic competition are a combination of perfect competition and monopoly. this is equivalent to P = LAC. since there are close substitutes available for any particular brand. except for one qualitative difference. such costs are “wasteful” from the viewpoint of the society. they incur advertising costs or what is also called selling costs. (c) is a monopoly feature in the following way. 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). which implies that abnormal profit is driven to zero.9 This closes our analytical discussion on market structure. there is only one firm producing a given brand.e. a major difference between monopolistic competition and monopoly in the long run. That is. all these are analogous to the case of monopoly. there is free entry and exit. however. the product is perfectly homogeneous and hence there is no scope to engage in persuasive advertisement. yet it is a unique brand. Even though a firm is small and produces a brand that has many close substitutes. namely. However.116 INTRODUCTORY MICROECONOMICS long run. i. Not all advertising costs are wasteful. 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 the letter “L” refers to the long run. implying that the AR curve must be quite flat. That is. Realise that such selling costs do not benefit the consumers as a group: they only serve to move consumers one brand to another. As we have already seen. There can be informative advertising (e. There is. But they involve resources. In perfect competition. Therefore. P = LAC. the demand curve facing a monopolistically competitive firm (unlike that facing a monopoly firm) is very elastic. See Clip 6-3 for a brief description of oligopoly. which can be potentially used for production. there is no need to engage in persuasive advertisement. we leave out one important form of an imperfectly competitive market. oligopoly. information about health). which is different from both perfect competition and monopoly. No one else produces exactly the same brand. monopolistically competitive firms typically engage in advertising. Unlike in monopoly. each firm has some monopoly power. . In other words. In monopoly. where MR = MC.

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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
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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

Derive its TR.) 0 10 20 30 40 50 60 70 6.) — 14 10 7 5 0 –3 –5 . Section III 6. Output (units) 0 1 2 3 4 5 6 7 MR (Rs.120 INTRODUCTORY MICROECONOMICS 6.46 Quantity Demanded (units) 8 7 6 5 4 3 2 0 The MR schedule of a monopoly firm is given below. under monopolistic competition. earn zero abnormal profits.44 Explain how in the long run equilibrium with free entry and exit. Derive the TR and AR schedules. Price (Rs.45 The demand schedule facing a monopoly is given below. firms. AR and MR schedules.

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. the average cost curve shifts down such that the minimum average cost is equal to Rs.OTHER FORMS OF MARKET STRUCTURE 121 6. Price (Rs. Suppose that the demand schedule for the product is given as follows.) 10 12 15 18 20 (a) Aggregate Quantity Demanded 1800 1440 1200 1000 760 6. . because of technological progress. 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.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.

U N I T-V FACTOR PRICE DETERMINATION .

determine income distribution in an economy.e. we examined the product markets: which good or service will be produced. Dissimilarities arise because the demanders and suppliers in a factor market are opposite of who they are in a product market. earnings to different individuals in the form of wage income or income from land etc. different types of labour or skill.FACTOR PRICE DETERMINATION 123 CHAPTER 7 FACTOR PRICE DETERMINATION • • • 7. in turn. land etc.. firms are demanders and households are suppliers. Income distribution. There are similarities and dissimilarities between product and factor markets.g.2 Total Factor Demand. Factor Supply and Equilibrium 7. In factor markets. Instead of the economy’s central problem of “what.3 Trade Unions In Chapter 2 to Chapter 6. determines differences . capital (i.” the factor market analysis sheds light on the “for whom” problem. In other words we dealt with the central problem of “what” facing an economy. For example. We will learn how the wages to different types of labour are determined in a market economy.1 Factor Demand 7. machinery and equipment). In general. how much and what its price will be. The issues are different also. The price of labour service is the wage rate. Households are demanders and firms are suppliers in product markets. consider the labour market. and if so. e. In this chapter we examine factor or input markets.

20 × 7 = Rs. are fixed. For simplicity. The way a firm’s 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. Let this variable factor be called labour. i.e.) In other words.1 FACTOR DEMAND 7. measured in hours of work. which will generate more revenues (as long as the marginal revenue is positive). The total cost of the variable factor (labour in our example) is easy to compute. we are not differentiating between different types of workers at the moment.1 A Firm’s Problem At a given point of time. Warehouse facility may be available at the rate of Rs. Realise that we have already studied (a) in Chapter 3. 80.. how many labour hours (denoted by L) a firm should employ? The total cost of fixed factors is fixed by definition.1. the total cost of labour is Rs. The prevailing hourly wage rate may be Rs.124 INTRODUCTORY MICROECONOMICS in the purchasing power over goods and services among individuals or households. 15. the total cost of labour or the total wage bill is Rs. 7. The question is. We also have analysed (b) − for a competitive firm in Chapter 4 and for a monopoly firm in Chapter 6. From Chapter 3. It employs workers. recall in particular the definitions of Total Physical Product (TPP) and the Marginal Physical Product (MPP). except one.2 One Variable Factor To begin with. This is how the factor market implications are linked to central problem of “for whom. 50 per day per cubic metre of space. What we need to do then is to combine what we have already learnt. The former refers to different levels of total output at different levels of employment . For instance. given factor prices. hiring more of factors will generate more output. The equality between demand and supply of a factor determines the respective factor price. If the firm hires 4 hours of labour.1. 140. Suppose that the wage rate is Rs. and so on. let us assume throughout this chapter that the firm under consideration is a perfectly competitive firm. On the other hand. If 7 hours of labour are hired. 20 per hour. 7. (If all workers are supposed to work a given number of hours per day. there is only one variable input and the rest are fixed. hiring more factors will cost more. think of a transport and storage company. suppose that the employment levels of all factors. 20 × 4 = Rs.” The similarity between factor and product markets lies in that there is a demand side and there is a supply side of a factor. how much of different factors a profit-maximising firm should hire? On one hand. rents warehouse space for storage etc. a firm faces different prices for different factors. The question is. then we can measure labour as the number of workers hired.

MPP (Rs.) 0 20 44 66 86 102 112 112 96 72 VMP = P. Consider the TPP schedule and the MPP schedule. MPP. The Table 7. defined as P × TPP.1 Labour Hours (L) 0 1 2 3 4 5 6 7 8 9 second one is the Value of the Marginal Product (VMP). we also know the shapes of the TPP and MPP curves. we need to know the product price. It is because an extra unit employed of a factor generates extra output equal to MPP.3 in Chapter 3.FACTOR PRICE DETERMINATION 125 of a factor.2 and 3. the MPP schedule as well as the associated TVP and VMP schedules. TPP. when the employment of other factors is unchanged. 2 TVP = P. which will fetch extra revenues equal to the value of this extra output. The first is the Total Value Product (TVP). Equivalently. This is indeed same as total revenue. defined as P × MPP.) — 20 24 22 20 16 10 0 –16 – 24 TPP 0 10 22 33 43 51 56 56 48 36 . In particular. Table 7.1 gives the TPP schedule. where P is the product price. In order to calculate the TVP and the VMP. as given in Tables 3. Suppose that P = Rs. From Chapter 3.TPP (Rs. 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. VMP is equal to the increase in TVP or total revenues per unit increase in the employment of the factor. TVP and VMP Schedules MPP — 10 12 11 10 8 5 0 –8 –12 Product Price = Rs. 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 inverse U-shape of the MPP curve follows from the law of diminishing returns. 2.

This is illustrated in fig. at L =2 (24) and at L = 3 (22). the total revenue). the hourly wage rate is Rs. This implies that the law of diminishing returns. Suppose that the factor L costs W per unit. Fig.. It is a horizontal line since the wage rate is unaffected by how many labour hours our (a) (b) Fig.126 INTRODUCTORY MICROECONOMICS Particularly relevant for us will be the VMP schedule and its properties. the graphical representation of a VMP schedule. at L = L1. also determines the nature of the VMP schedule. If. 7. i. 7.2 Factor Price Line .1(b). It initially increases with factor employment and then diminishes. which governs the nature of the MPP schedule.1(a). which is constant. the TVP is equal to the area 0ABL1. 7. 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. Fig. TVP = 66. if we draw a smooth VMP curve. This is equal to the sum of VMPs at L = 1 (20).e. For instance. a small firm − hires in the labour market.e. For instance. 7. will be inverse Ushaped. 7. just as the MPP curve. It is proportional to the MPP schedule as it is obtained by multiplying the MPP schedule by price. the area under it will be equal to the TVP (i. for instance. Property B implies that.1 The VMP Curve competitive firm − by definition. the firm hires L1 labour hours. A general. at L = 3. 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. W. Now we discuss how it affects its costs. TVP of a particular level of factor employment is the sum of VMPs up to that level of employment. smooth VMP curve is shown in fig. its total wage bill is the area 0WCL1. A.2 draws the Factor Price Line or the “wage line” in this case. B. Property A implies that the VMP curve.

any deviation from the principle (A) will only generate less profit. This proves that profit is maximised at L = L0. However.1 Now consider any employment level less (such as LA) or more (such as LB) than L0. the VMP will be less than the factor price. which is equal to W0 AC – CDF. Fig. 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). is equal to the area W0 AC. under diminishing returns. The adjective “gross” is attached. Indeed the two conditions are two sides of the same coin. By definition. At L = L0 . For instance. 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. 7. Turn to fig. if the firm hires one less unit than where VMP is equal to the factor price. it should hire L0 labour hours. At L = LB.3. which is the difference between TVP and total factor cost.FACTOR PRICE DETERMINATION 127 We are now ready to derive the principle that governs how many labour hours a profit-maximising firm should hire. . The law of diminishing returns is the key. The answer is that the firm should hire up to that level. where the factor price line intersects the VMP curve. In other words. which combines figs. Thus the gross profit. it is equal to W0 AC – CEG. We can compute that the profit is less than W0 AC. profit = gross profit – fixed cost.3 Factor Employment Decision This condition is perfectly parallel to the profit-maximising condition for a competitive firm. i. In summary. gross profit is maximised where profit is maximised and vice versa. The rationale behind condition (A) is also parallel to that behind P = MC. As a result. TVP or total revenue is equal to the area 0ACL0. Similarly. Let the factor price facing the firm (wage rate) be W0. The total factor cost is equal to the area 1 0W0 CL0.1(b) and 7. it is equal to W0 AFD.2. since fixed costs are not deducted. 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). that is P = MC. at L = LA. 7. Thus profit will be less. 7. This proves why profit is maximised when condition (A) is met. the VMP will be higher than the factor price. since the fixed costs are given.e. This implies less profit than before. the general principle of hiring a factor (or profitmaximisation with respect to a particular factor) is (A) VMP of a Factor = Its Price.

This means that the downward portion of the VMP curve is the firm’s demand curve for the factor. increases the VMP at any given level of factor employment. For instance. anything that shifts the VMP curve shifts the factor demand curve. make the handicraft. Suppose that in an international exhibition this handicraft attracts a lot of attention. Next we examine the determinants or the sources of shift of the factor demand curve. A Change in Product Price By definition. The increase in the price of the handicraft will shift their VMP curve and hence the demand curve for artisans to the right.2 It also means that a firm’s demand curve for a factor is downward sloping. The general point here is that factor demand is. P. the factor demand curve shifts to the right (or up). factor demand is said to be a derived demand.3 Factor Demand Curve Shifts Since the factor demand curve is a part of the VMP curve. On the demand side. we can say that an increase (a decrease) in the product price shifts the factor demand curve to the right (left). 7. In general then. in a sense. From the demand-supply analysis in Chapter 5 we know the effect: the price of this handicraft increases.128 INTRODUCTORY MICROECONOMICS Factor Demand Curve Note from the preceding discussion that a firm always chooses a point on the VMP curve.1. Many people and organisations around the world come to know about it and they like it. 7. On the supply side. the product is sold in 2 Fig. This is why. Now consider the (factor) market for artisans. From this result. We consider the following sources of change.4. This is illustrated in fig. . As a consequence.MPP. never at a point where diminishing returns do not hold. who. Hence an increase in the product price. derived from product demand. and moreover. consider the industry of a particular handicraft. 7. This is parallel to the supply curve of a firm being same as the upward sloping portion of the marginal cost curve. we can see a link between product and factor markets.4 Product Price Increase and Factor Demand India and abroad. there are artisans. VMP = P. with the help of raw materials and equipment. Consequently there is an increase in demand for this handicraft.

different types of labour.MPPX = WX . (b) Technological Change lowering the MPP of a Factor Fig. Fig. In reality.3 Marginal Productivity Theory of Distribution So far we have assumed that the firm employs only one variable factor of production. and their respective marginal products are MPPX and MPPY. the profit-maximising principles are: (A') VMPX = P. . then the demand curve for that factor shifts to the right. their respective prices are WX and WY. power. is the change in the employment of other factors. which we have not discussed and which is something to be done in a higher course in microeconomics. if the MPP of a factor decreases due to a technological change. in recent two/three decades. 7. VMPY = P. say X and Y. 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). land etc. firms employ many. even when the product price is unchanged. then its demand curve shifts to the left.5(b) illustrates this. various kinds of machines. it is widely believed by economists that.5 Technological Change and Factor Demand Technological Change A technological change can alter the MPP of a factor and thereby its demand curve. there are two factors.5(a) shows this effect. Fig. If. for example. If it is 3 Another possible source of a shift in the factor demand curve. For example.FACTOR PRICE DETERMINATION 129 (a) Technological Change increasing the MPP of a Factor such that the MPP of a factor increases. e.MPPY = WY. 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.1. 7. 7.g. Otherwise.. raw materials.3 7.

We have derived a single firm’s demand for a factor. the marginal productivity theory does hold. we get the total industry demand curve for that factor. MPPY Hence. the central problem of “for whom” facing an economy. 4 In principle. If the salaries of school teachers increase. for example. and.2 TOTAL FACTOR DEMAND. 5 We now turn to the supply side. let us return to the one-factor case. because the (marginal) productivity of skilled workers is greater than that of unskilled workers. In Fig. Consider. not just by demand forces that we have emphasised so far. teaching service as a factor of production (in producing education).130 INTRODUCTORY MICROECONOMICS That is. In order to see this and analyse factor market equilibrium in general. from Chapter 1. each factor ear ns the value of its marginal physical product. when we do take into account the supply side. It is called the marginal productivity theory of distribution. suppose that factor X is skilled labour. the total demand curve for a factor is the horizontal summation of individual (firm) demand curves for that factor in various industries combined. How DD is derived is parallel to how the product market demand curve is derived from individual demand curves. that is. more people than before will be willing to choose school 5 The derivation of total demand for a factor is more complicated than the derivation of market demand curve for a commodity. To simplify the discussion. if MPPX > MPPY. That is. the price of the commodity is implicitly kept constant during this summing up. with appropriate interpretation. which concerns who earns how much. WX is the skilledlabour wage and WY is the unskilledlabour wage rate. Then from (A´). factor Y is unskilled labour. that skilled workers normally earn more than unskilled workers.MPPX P . The conditions (A') imply a theory of this. skilled labour earns more than unskilled labour. There are many fir ms in a per fectly competitive industry. factor prices should be determined by forces of demand and supply both.4 However. This complication arises due to a change in the price of the commodity when all firms increase or decrease their outputs together.6(a) and (b). let P be the price of the good produced in that sector. However. the total demand for a factor is shown as the line DD. then WX >WY . FACTOR SUPPLY AND EQUILIBRIUM WX WY P . 7. if we sum up the demand for a factor across various firms.MPPY MPPX . Recall. some factors are used in many industries and in that case. 7. for example. So. To see this more exactly. the definition of MPP remains valid. 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. Both work in the same sector. This theory implies. .

Hence the supply curve of this factor service is upward sloping.6 applies except that “rent” substitutes the “wage rate” and “land” substitutes “labour. In the short run the land supply is given. a firm hires land. This is. capital etc. take years. There are exceptions. Here land does not just mean a piece of land per se but includes room. denoted by SS. because teachers’ education. Higher the rent. if we interpret land narrowly in terms of area on ground. The intersection of demand and supply curves defines equilibrium in the factor market − similar to what happens in a product market. Fig. This is true for almost any type of (relatively high) skill. The short run and long run factor supply curves. 7. the supply of land to a particular industry is upward sloping (in the long run). The equilibrium wage is denoted by W0. It is different from price of land as an asset. 7.6 Hence the long-run supply curve of land is upward sloping also. Countries like Japan and Hong Kong have claimed land from sea.6 respectively. building floors etc. Besides different types of labour. E denotes the market equilibrium point. In the short run.7 In the present context this is the “price” of land in terms of its service as a factor of production. 6 7 (a) Short Run (b) Long Run Fig.” A point to note here is that. true in the long run. training and certification etc. the supply of school teachers in a particular region will be given. These are examples of non-human factors of production. and N0 denotes the equilibrium amount of the particular skilled labour that is hired. In the long run it is likely to change. Supply and Market Equilibrium of a Particular Skill Thus the land market equilibrium is similar to that of a particular skill. 7. The earning of land is the rent per unit of space. Consider for instance the supply of land.6 Demand. In both panels. however.FACTOR PRICE DETERMINATION 131 teaching as a career. like over a few months or over a year. but land supply to the entire economy is given. . more land or space will be supplied by landowners. of a particular skill are shown in panel (a) and panel (b) of fig.

6 applies to the market for a particular type of capital. 7. which is higher than what the equilibrium wage rate would have been in the labour market. A technological change that improves the MPP of a factor will enhance its reward.g. By now this conclusion must be something very evident to you. In any event. What effect does this “wage-fixing” by trade unions have on the labour market? Turn to fig. the wage of this skill (e. the production of which requires a specific skill (e. Very often they also try to bargain for higher wages than the employers are willing to offer. For instance. In the factor market.3 TRADE UNIONS The demand-supply analysis above refers to how the price/market mechanism works in factor markets. from the demand side. This is parallel to our demandsupply analysis for commodities in Chapter 5. B. fig. 7. It is dissimilar to land in that the total capital stock in an economy is “reproducible”. If you own an Ambassador car and use it for taxi business. It is similar to land in that it is non-human. It can be applied to various sources of shifts and their effect on factor price.7. Here it means plants. there is also an important example where a factor price is not determined by the market. 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). then the hourly or daily rate you charge is an example of capital earning rental. These unions voice grievances of workers in a collective way. 7. There are two general implications of our factor demand-supply analysis. A. whereas the total land space is non-reproducible. Sometimes they succeed in negotiating a wage rate. it can be increased continuously over time.e. where Ls denote the total number of workers. The . equipment. 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. machinery etc. You might have heard of workers’ organisation in various sectors of the economy called trade unions or labour unions.g. We say that capital earns rental. The term capital in economics means different things in different contexts. 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. of computer engineers) will increase. if there is an increase in the demand for a commodity. Whichever factor is under consideration. at the equilibrium point. Sometimes they organise strikes and boycott work for days and weeks. i. This is the supply curve of labour. the factor reward is equal to the value of its marginal physical product. computer skills).132 INTRODUCTORY MICROECONOMICS Capital is also a factor of production.

If there were no trade unions. the VMP curve of a factor is generally inverse U-shaped.FACTOR PRICE DETERMINATION 133 demand curve for labour is denoted by LD. the intersection of the labour supply and labour demand curves would have determined the market wage rate. An increase in the product price shifts out the demand curve of a factor. the demand for a factor is “derived demand. The total factor cost or payment to a factor is the area under the factor price line. which is higher than W0. unemployment sometimes may be caused by the presence of trade unions. L 1 L s measures the number of workers who are unemployed. Fig. which is indicated at the point D1 on the labour demand curve. What we see now is that there is unemployment of labour. 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.7 Trade Unions and Unemployment Thus. As a result. the firms will demand less labour. TVP of a factor is equal to the area under its VMP curve. For a competitive firm. The demand curve for a factor is essentially the downward sloping portion of its VMP curve. In this sense. For a competitive firm. profit maximisation occurs when each factor is paid its VMP. In the diagram. For a competitive firm.” . 7. at the point L1 on the horizontal axis. Now suppose that the trade union fixes the wage at W1. This is because of the law of diminishing returns. W0 would have been market wage. or equivalently.

is different from land in the sense that.1 7.134 l l l l l l l l INTRODUCTORY MICROECONOMICS The MPP of a factor and hence its demand curve can shift because of technological changes.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.8 7.4 7. The total demand curve for a factor is the horizontal summation of individual (firm) demand curves for that factor.9 7. EXERCISES Section I 7.5 7. It is because.10 7.3 7. An increase in the demand for a factor tends to increase its price.6 7. Skilled labour is paid more than unskilled labour because the marginal product of former is higher than that of the latter.2 7. unlike land. unemployment results in the labour market. at a higher wage rate.11 7. but it may be vertical in the short run. When a labour union fixes a wage above the market-clearing wage. while the supply of labour by workers may increase or remain unchanged. Marginal productivity theory implies that different factors are paid differently because of differences in their VMPs. as a factor of production. while an increase in the supply of a factor tends to lower its price.12 7.7 7. What is the relationship between the wage rate that a labour union typically fixes and the equilibrium wage rate? . Capital. The supply curve of a factor is upward sloping in the long run. it is typically reproducible. firms employ less labour.

The law of diminishing returns holds. The price of the product is Rs. Show that. which were used for renting.18 7. 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. 12. 5. At some level of employment.17 7.000. MPP = 5. The TPP schedule of a factor is given in the following table. 40.22 The total payment to a factor is Rs.14 The TVP at the employment level L = 4 is 50 units.15 7. Employment of a Factor 0 1 2 3 4 5 6 7 8 7. How many units of that factor are being employed? Suppose that the product price is Rs.16 TPP (units) 0 8 20 32 42 50 56 60 62 7. That at L = 5 is 65 units. Should the firm increase or decrease employment in order to increase its profits? Explain why a factor demand is called “derived demand. All other things . What is the MPP at L = 5? The product price is Rs. at this level of employment.FACTOR PRICE DETERMINATION 135 Section II 7.20 7.21 7. 10 and a factor is paid Rs.” What does the marginal productivity theory of distribution say about the earnings of different factors? Explain why skilled workers earn more than unskilled workers. Derive its VMP schedule.19 7. The price of the factor is Rs. profit is not being maximised. 70 per unit. 3.

under perfect competition. How will it affect the wage of unskilled labour? Section III 7.23 remaining unchanged. Explain why. .25 Explain how profit is maximised when the VMP of a factor is equal to its price. 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. the VMP curve for an input is considered its demand curve.136 INTRODUCTORY MICROECONOMICS 7. How will it affect the wage of skilled labour? Further suppose that the technology advance lowers the MPP of unskilled labour.24 7.

in the sense that each party has something to offer to the other. we will understand that promoting international trade is not a bad thing. we learn a very important concept in economics. consumers and producers across countries.. and. are much more interdependent today than they were 30 or 40 years ago.3 Factor Mobility • • • In previous chapters we studied how producers and households interact with each other in product and factor markets. India exports tea to the rest of the world and imports petrol. In the process. In this chapter. This is very important. On the contrary.2 Factor Endowment Theory of International Trade 8. our objective is to learn some fundamentals of international trade. Through this concept. i. it is not true that. This is called international trade. trade/exchange with each other in goods and services.1 Ricardo's Theory of Comparative Advantage and Benefit from Trade 8. we will . in general. some other country has to lose. if one country gains from it. We can think of such interaction as “trade” between producers and households. Not only producers and consumers within a country trade with each other.COMPARATIVE ADVANTAGE. because countries. the countries themselves. called comparative advantage.e. Many foreign banks today offer banking services in India. INTERNATIONAL TRADE AND FACTOR MOBILITY 137 CHAPTER 8 COMPARATIVE ADVANTAGE. INTERNATIONAL TRADE AND FACTOR MOBILITY 8. which is an example of trade in services. As an example of trade in goods.

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. 300 per hour. The idea behind comparative advantage (to be defined in Section 8. in comparison to producing all goods it can produce and not trading. Consider now the alternative option of hiring a cook and engaging yourself full time in singing. singing). Suppose that you are a very good pop singer and a very good cook. As we will see. a mutually beneficial activity. But you are much more productive as a singer than as a cook. In simpler language.138 INTRODUCTORY MICROECONOMICS learn that trading with each other is. named David Ricardo. it implies that countries can trade and benefit by exploiting their differences. cooking) and. Which option will you prefer? Surely.1) and gains from trade can be understood through this example. This is the idea behind comparative advantage. both are better off by trading with each other. 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. What applies for an individual in the above example also applies to a country. In what follows. One option for you will be to pursue a singing career and still cook for yourself – be “selfsufficient”. 300 per hour. so-to-speak.e. A country. That is. i. differences in factor supplies across countries. It is the simplest and yet a very elegant exposition of how international trade can be beneficial to a country. you save Rs. it means that you and I are different. Now think about this example in a different light. by and large. The latter option is like importing the service that you do not have comparative advantage in (that is. 5. Put differently. and you have something that I want but cannot get that easily. we first discuss Ricardo’s theory of comparative advantage. This is in the sense that if you sing you get Rs. We also consider another source (basis) of comparative advantage. . The next two sections study these alternative sources of comparative advantage.. if you cook.000 per hour. namely. whereas you can hire an excellent cook at the rate of Rs. the latter. This principle was first demonstrated formally by a famous English economist. you are capable of doing both and you actually choose to do both. specialising and exporting the service you have comparative advantage in (that is. Although Ricardo wrote about it almost two hundred years ago (in the early 19th century). Ricardo’s theory of comparative advantage and trade is based on differences in technology across countries. I have something which you want but cannot obtain that easily. its relevance is felt even today.

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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 RICARDO’S 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 India’s 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 country’s “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

let there be “free” trade. 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). 4. it means that the world relative price of football will be in between 2 and 4 cricket bats. 3. in general. not because they are critical for our argument. the exchange ratios will be the same.e. 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. we cannot determine the world terms of trade exactly. It is because. This is intuitive. In Australia for example. and cricket bats are relatively cheaper in Australia. assume that there is no transport cost of moving goods between the two countries. But we do not have any information on the demand side. Further. Range of World Terms of Trade The next question is: what will be the equilibrium world terms of trade? Terms of trade. (We make these strong assumptions. We can call these the domestic exchange ratios. i. Also notice from the exchange ratios that football is relatively cheaper in India.142 INTRODUCTORY MICROECONOMICS other good that one gets in exchange for one unit of the good in question. You can similarly calculate the exchange ratio in Australia: 4 cricket bats for 1 football. It cannot exceed 4 or fall short 2. Why? Suppose it exceeds 4. say . no restrictions like trade taxes or any limits on how much a country can export or import etc. which has comparative advantage in producing cricket bats. if a good is cheaper in one country than in the other. Also. which has comparative advantage in producing football.. The stage is ready now to understand the effect of international trade.1. The supply side of an economy is represented by the PPC of a country. We then have the exchange ratio in India in the no-trade situation equal to 2 cricket bats for 1 football. 8. In this example. In equilibrium. Hence. find its range: it will lie in between the domestic exchange ratios. We can call this the world exchange ratio or what is called the world terms of trade. Put differently. it is an exchange ratio between goods.4 Effect of International Trade Let India and Australia now open up trade. 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 relative price of football is 4 cricket bats and the marginal opportunity cost of football is also 4 cricket bats. We can. however. every one in both countries will buy the product from the former country and this will push its price up.

suppose that they are equal to 1 football for 3 cricket bats. you can group them into the “home” country and “the rest of the world” and the same argument holds. Consumption Possibilities Now we come to the last stage of our discussion. Exports of a commodity are equal to its production minus its consumption. From the viewpoint of India. 8. This process will continue until there is no production of cricket bats in India. a football fetches more than it fetches in the no-trade situation and thus both would like to export football. As an example. produces football only. Assume that the world terms of trade lie strictly in between the two domestic exchange ratios. in the production of which India has comparative advantage. . This is how international trade affects production and resource allocation in an economy. What are the consumption possibilities facing the two countries and how do they benefit from trade? But before we address this question. Specialisation occurs as the world terms of trade are different from the domestic exchange ratio. in the production of which it has comparative advantage.COMPARATIVE ADVANTAGE. which is greater than its the marginal opportunity cost (equal to 2 cricket bats). a trading country specialises in the good. if a good is exported (imported). Then. then its production exceeds (falls short of) its consumption in the country. In other words. the relative price of football is 3 cricket bats. the two countries comprise the world economy. Hence resources (labour) will move out of the cricket bat sector to the football sector. as long as the world terms of trade differ from the domestic exchange ratio. in both countries. Specialisation Now think about how much of each good will be produced in the two countries. i. (When there are more than two countries.) You can similarly argue that if the world terms of trade are 1 football for something less than 2 cricket bats. Mark that football is the good. This will mean that there are abnormal profits in the football sector. This proves that the equilibrium world terms of trade will lie between the domestic exchange ratios. whereas imports of a commodity are equal to its consumption minus its production. INTERNATIONAL TRADE AND FACTOR MOBILITY 143 1 football for 5 cricket bats. That is. in which it has comparative advantage. We can then summarise that in the Ricardian world economy. 8.2.1 (shown by the dashed lines).e. This is shown in fig. India’s and Australia’s production points in free trade are shown at points D and H respectively. since there is no third country they can both export to: by definition. India “specialises” in football. By similar argument. we should know what we mean by exports and imports. which graphs the same PPCs as in fig. But this is not possible. both countries would want to import football and that is not possible. Australia specialises in cricket bats.

2 The concept of slope of a straight line is explained in Appendix 2. 8. Note that. That is. whose slope is also equal to 3.2. since India produces at D. irrespective of which consumption points on DE' and G'H are chosen. the consumption possibility curve for India at the world terms of trade. there is at least one point on DE'. India exports footballs and Australia exports cricket bats.. e. is the heavy line DE'. Alternatively. the relative price of football in the world market. you can see that for every possible consumption point in the no-trade situation. By similar argument. whose slope is 3. Hence.144 INTRODUCTORY MICROECONOMICS (a) India Fig. 8. . This situation is surely a better proposition for India than no trade. except the corner points on the PPC. These possibilities give rise to the heavy line DE'. The line G'H lies outside Australia’s PPC.g. Australia’s consumption possibility curve is now the heavy line G'H. which only offered the consumption possibilities along the PPC that lies to the left of or “inside” the line DE'. equal to the relative price of football in the world market. A. which guarantees more consumption of each good. For instance. it can export one football in exchange for 3 cricket bats (all imported). one consumption possibility for her is the point D itself.2 (b) Australia Free International Trade in the Ricardian Economy In fig. free trade must be preferred to no trade. or 2 footballs in exchange for 6 cricket bats (all imported) and so on. 2 Put differently. But there are other possibilities. Thus Australia also benefits from free trade. equal to 1 football for 3 cricket bats.

In our example. 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. just like labour endowment in the Ricardian theory. labour and capital. no country will have comparative advantage in producing any good and there will be no reason to trade. let L A and KA denote the endowments of labour and capital in America. Suppose that the supply of each factor in each country is given. we can always compare it between countries. There are constant returns to scale. if the ratio of labour coefficients is the same between the two countries. We can call these factor endowments. For example. India (N) and America (A). This is a very general principle of international trade. This is true even when a country is more efficient in producing all goods in an absolute sense.2. Even if international trade is opened between the two countries. we say that It was formulated originally by two Swedish economists. These are absolute factor endowments. it is the difference in technology that forms the basis of comparative advantage and mutually beneficial trade. Instead of one factor of production. suppose that there are two.COMPARATIVE ADVANTAGE. 8. Likewise. 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. Otherwise. . Eli Heckscher and Bertil Ohlin. then the domestic exchange ratios will be the same.3 View the world as having two countries once again.4 All markets are perfectly competitive. Differences in relative factor endowment (to be defined in a moment) form another major basis for comparative advantage. 8. They produce two goods: Chairs (C) and Medicine (M). nothing will change in any country.1 Factor Endowment Difference Let LN and KN denote the endowments of labour and capital in India. They are required in producing each of these two goods. The theory 3 4 that brings out this point is called the factor endowment theory. Furthermore. say. However. Having defined relative endowment. INTERNATIONAL TRADE AND FACTOR MOBILITY 145 each country exports the good it has comparative advantage in. The ratio of absolute endowments is called the relative factor endowment. But the idea here is to suppress such difference and focus on difference in factor endowments. and is called the Heckscher-Ohlin theory. technology differences are not only basis for comparative advantage and trade. It is not that the technology cannot differ between countries. LN/KN is the relative endowment of labour in India.2 FACTOR ENDOWMENT THEORY OF INTERNATIONAL TRADE In the Ricardian theory.

2. the wage/rental ratio in India will be less than that in America. 1.000. our relative factor ranking (A) implies this. How? Our analysis of factor price determination in Chapter 7 comes into play. compared to America. 900 respectively. In other words. LA=2. because the ranking (A) does not say anything about absolute endowment levels. the wage/rental ratio is greater in America. India is the relatively lowwage country and America is the relatively high-wage country. there can be an absolute difference in the rental rate of capital between the two countries. In India. and thus L N/K N>L A/K A. 200 per day in America.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. LA/KA = 2. can we say anything about absolute factor price differences between India and America? The answer is no. since it is reasonable to suppose that India is a relatively labour-abundant country. the lower is its reward. In general. in America. 200 and capital earn rental equal to Rs. let LN = 1. where relative factor price is defined as the ratio of factor rewards. since India (respectively America) is relatively labour – (respectively capital)– abundant. greater the supply of a factor. 8. Then LN/KN = 3. 100 and Rs. 500. 8. 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. we say that relative reward (price) of labour is greater in America and the relative reward of capital is greater in India. But. Thus. In this case.5 KA Let us assume this. .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. if labour earns wage equal to Rs. Given our ranking of the relative endowment in (A). labour earns wage equal to Rs. Similarly. it implies that.2. if ( A) LN KN LA .000 and KA = 1000. we say that there is an absolute wage difference and the wage rate is less in India than in America. Suppose that. But it can say 5 something about relative factor price difference. For instance. It is 1/5 there and 1/9 in India. Indeed. the two absolute factor rewards are less in India. 50 per day in India and Rs.146 INTRODUCTORY MICROECONOMICS India is the relatively labour-abundant country and America is the relatively capital-abundant country. Let us invoke a result from that chapter which states that. KN = 500. relatively speaking. let the wage rate and the rental to capital be Rs. In the present context.

country (America) will export the relatively capitalintensive good (medicine). Ask yourself which good will be produced more efficiently (i. in an economy. we can say that the relatively labour-abundant. the factor endowment theory has been merely sketched. country (India) will have comparative advantage in producing the relatively labour-intensive good. The relatively capital-abundant. This is the gist of the factor endowment theory. . high wage/rental ratio country (America) will have comparative advantage in producing the relatively capitalintensive good.COMPARATIVE ADVANTAGE. and. Three remarks are in order. This is because changes in product markets affect the demand for a factor.e. Joining the two links now. INTERNATIONAL TRADE AND FACTOR MOBILITY 147 two countries. capital-abundant country. The relatively labour-abundant. In contrast. the capitalintensive good (M) will be produced relatively more efficiently in the relatively high-wage. You can reflect back to see that the aforementioned result is quite reasonable. In Chapter 7.compared to no trade. 2. 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. the factor endowment theory illustrates how factor market differences influence the product market − the pattern of flow of goods between countries.e.4 International Trade Thus far we have linked relative factor endowment difference and relative factor price difference to comparative advantage. in free trade.2. a country will produce more and export the product.. We next link comparative advantage to international trade: i. low wage/rental ratio. We can state this in terms of comparative advantage. we learnt that the demand for a factor is called a derived demand. A specialised course in international economics will deal with this theory in more detail. with lower cost) in the low wage/rental ratio country and in the high wage/ rental ratio country. The answer is that the labour-intensive good C will be produced relatively more efficiently in the relatively low-wage. factor and product markets are very much interrelated. in which it has comparative advantage. 8. Thus. labour abundant country. 1. high wage/rental ratio. country (India) will export the relatively labour- intensive good (chair) and the relatively capital-abundant. Unlike the material in previous chapters and our discussion of the Ricardian theory. Remember that the production technology of chairs (C) is labour-intensive and that of medicines (M) is capital-intensive. low wage/rental ratio. a general and an important point to be learnt is that. This is how the relative factor endowment difference and the relative factor price difference are linked to international trade.

India exporting relatively labour-intensive goods can be thought of as India exporting the “services” of labour. Both these factors imply higher demand for daily labour in urban areas. exports relatively labour-intensive goods and America. both husband and wife work outside the home. There are thousands of workers from India who are working in middle-east countries like Kuwait and Yemen. . That is. We now ask why factors move the way they do? Here. international trade in goods can be seen as international trade in factor services. the relatively capitalabundant country exports relatively capital-intensive goods. which explain the rural-urban difference in daily wage. we have already noticed that in India daily labour moves from rural to urban areas. Why is this so? Because. is just an immediate cause of factor/labour migration. there is an absolute factor price difference. factors do move between regions and countries. unlike in the factor endowment theory. Unskilled labour moves from Mexico to America. This again shows how interrelated goods and factor markets are. In our country daily labour moves typically from villages to towns. America exporting relatively capital-intensive goods means that America is exporting capital services. Put differently. compared to rural areas. Likewise. Also. First. India. cooking etc. However. As an example. Given such a difference. Indeed there are differences in both demand and supply sides. These are not the only instances of mobility. We can look at this conclusion in a different light.3 FACTOR MOBILITY The very last point made brings us to the very last topic to be analysed in this book. it is as if factors are moving internationally. This chapter − and the book − ends with an investigation of why a ruralurban wage differential exists.148 INTRODUCTORY MICROECONOMICS 3. 8. although they are not (in our analysis). construction works are more prevalent in urban than in rural areas. as opposed to joint families. the relatively labour-abundant country. In our example. In many urban households. the absolute factor price difference (already defined) plays a role. studied in Chapter 7. This induces it to move from rural to urban areas. Daily labour earns more in an urban area on an average than in a rural area on an average. the absolute factor price difference or in this case the ruralurban wage differential. We can think of this issue in terms of demand and supply of a factor. Skilled workers move typically from countries like India and China to Europe and America. in urban areas than in rural areas. not the underlying cause. a factor moves from the low-reward region to a high-reward region. Recall the central prediction of the factor endowment theory. Hence there is a greater demand for household services like cleaning. there are more nucleus families.

SSR. In the Ricardian theory. marks that in the rural area. Average physical product a factor is the inverse of its coefficient. The one to the left. the labour market equilibrium in the rural area occurs at the point ER where the curves DDR and SSR intersect. differences in technology form the basis of comparative advantage. INTERNATIONAL TRADE AND FACTOR MOBILITY 149 Second. which earns less rental in capital-abundant developed countries. This implies that. We can see this in terms of fig. The urban labour market equilibrium is shown at the point EB where DDB and SSB intersect. We should carefully note however that absolute factor price difference is only an immediate cause − or an indicator − of factor movement. . 8. high-rental.3 Urban and Rural Wage for Daily Labour We note that this is true not just for unskilled labour but also for skilled labour. As we can see clearly. WR. SSB.3. Fig. the supply of daily labour in towns is less than in villages. has an incentive to move (through multinational firms) to capital-poor. 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. can be interpreted as the demand curve for daily labour in the urban area and the one to the left.COMPARATIVE ADVANTAGE. marks the supply curve in the urban area and the one to the right. developing countries. Once we establish that there is an absolute difference in wages. the urban wage. Likewise. and Europe in order to earn higher wage for their skill. Similarly. 8. can be thought of as that in the rural area. 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. it is easy to predict that labour wants to move from a low-wage region to a high-wage region. There are also two supply curves. ceteris paribus. Both these factors together imply that the urban wage must be higher. DDR. Skilled workers want to move out of countries like India and China to the U. capital. There are two demand curves. WB is greater than the rural wage. The one to the right. DDB.S.

constant labour coefficients imply that the marginal opportunity cost of a good. absolute factor price difference arises because of variations in demand and supply factors in respective regions. as families of many daily workers prefer to live in rural areas. . In the absence of trade. a country specialises. This is true even when a country is more efficient in producing all goods in an absolute sense. Compared to rural areas. not the underlying cause. in the good in which it has comparative advantage. a country’s PPC is same as its consumption possibility curve. Higher cost of living in urban areas implies less supply of daily labour in these areas. This is because of greater demand for daily labour and less supply of daily labour in the urban areas. in free trade. In turn. is constant. 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. The world terms of trade lie in between the domestic exchange ratios. In the Ricardian economy. in terms of the other along the PPC. as long as the world terms of trade are different from the domestic exchange ratio. This is captured by the factor endowment theory. in urban areas. the daily wage rate is higher. This in turn implies that the PPC is a straight line. The differences in relative factor endowment also form a basis of comparative advantage. The greater demand for daily labour in urban areas stems from higher demand for household work and construction projects. The Ricardian theory illustrates that a country benefits from international trade by specialising and exporting the products that it has comparative advantage in.150 l INTRODUCTORY MICROECONOMICS l l l l l l l l l l l l l In the Ricardian economy. the consumption possibility curve in free trade lies outside its PPC. of factor mobility. In the Ricardian economy. as long as the world terms of trade are different from the domestic exchange ratio. Absolute factor price difference is the immediate cause. 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.

Two goods are produced: sitar and guitar. 8.COMPARATIVE ADVANTAGE. 5 units of labour is required to produce one sitar and 12 units of labour is required to produce one guitar. what is the relationship between a country’s 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. in a two-country Ricardian world economy. Explain how.13 Section II 8.1 8.8 8.10 8. What does the Ricardian theory emphasise as a basis of comparative advantage? In the Ricardian theory. What is meant by labour coefficient? Give the meaning of absolute advantage.9 What is meant by international trade? Give one example of international trade in services. in the free-trade situation. Give the meaning of comparative advantage. labour. Explain the concept of comparative advantage by using a suitable example.14 8.18 8. there is one factor of production.19 .7 8. Determine which country has absolute advantage and comparative advantage in which good.12 8.6 8. in the Ricardian world economy. In an economy.11 8.3 8.17 8.16 Give two examples of international trade in services.2 8.5 8. INTERNATIONAL TRADE AND FACTOR MOBILITY 151 EXERCISES Section I 8. which good does a country specialise in free trade? In the no-trade situation. what is the relationship between a country’s PPC and its consumption possibility curve? In the Ricardian theory. Explain that. The following table gives labour coefficients in the two sectors in two countries. Determine the domestic exchange ratio between sitars and guitars in this country.15 8. constant labour coefficients imply that the PPC is a straight line. both countries cannot have comparative advantage in producing the same good.4 8.

Suppose the endowments in the two countries are as given in the following table. Determine which country now has absolute and comparative advantage in which good. Suppose technological progress occurs in Popland.29 Refer to the previous question.22 8. If the world terms of trade facing this country are 1 tooth brush for 4 shoe brushes.30 8.27 8. labour and land. As a result.23 8. Name two labour-intensive commodities in India. The world consists of two countries: Blueland and Yellowland.21 8. the labour coefficients are now 40 and 30 respectively for the sitar sector and the guitar sector. The production of apples is relatively more land intensive compared to grapes. .152 INTRODUCTORY MICROECONOMICS Popland Sitar Guitar 8. determine which country will export what. Name two relatively capital-abundant countries. A Ricardian economy can produce two goods: tooth brush and shoe brush. Name two commodities which are relatively capital-intensive in production. If both countries engage in free trade with each other. Explain absolute factor price difference.800.26 8.31 Give two instances where factors are mobile.20 50 60 Rockland 60 50 8. There are two factors. They produce two goods. Blueland Labour Land 50 70 Yellowland 60 140 8.24 8. Why may it arise? Explain relative factor price difference. apples and grapes.28 8. Its labour endowment is equal to 1. Differentiate (with example) between a capital-intensive good and a labour-intensive good. Why may it arise? Name two commodities which are relatively labour-intensive in production. determine how many tooth brushes and shoe brushes this country will produce in free trade. Name two relatively labour-abundant countries. The labour coefficients in these two sectors are respectively 30 and 90.25 8.

how will it affect the salary of computer professionals in India and abroad? .34 8.35 Explain why a relatively labour-abundant country will export relatively labour-intensive goods.33 8. Analyse why daily wage is higher in urban areas than in rural areas. How will it affect the urban and rural wage for these services? Section III 8.32 Suppose the supply of workers for household services declines in the economy.COMPARATIVE ADVANTAGE. Ceteris paribus. Suppose that many of our computer professionals migrate to foreign countries. INTERNATIONAL TRADE AND FACTOR MOBILITY 153 8.