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N T R O D U C T I O N
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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.
Unfortunately, this may be true only in heaven, not in the real world. Even the richest person on earth would have to face scarcity and make choice. If nothing else, time is scarce. Ratan Tata, a leading industrialist of India, between 6 p.m. and 8 p.m. in a particular evening, may have to decide whether to go to a musical concert, or just keep working in his office. Think about the length of syllabi of various subjects that you have to cover before the final exam. We do not need to convince you that time is scarce. Likewise, food, clothing, housing, clean air, drinkable water etc. are scarce in every country in the world, except that the degree of scarcity varies. The point is that problems of choice arise because of scarcity. The study of such “choice problems”, at the individual, social, national and international level is what economics is about. 1.1 CENTRAL PROBLEMS OF AN ECONOMY: WHAT, HOW AND FOR WHOM There are many choice problems that any particular economy attempts to solve within a given time period. For example, during the fiscal year 1998-99, 71.3 million tons of wheat was produced in India.1 Output of food grains in general is not entirely determined by external factors like
1 2 3
rainfall etc. It is partly influenced by how much of land is used to raise food grains, by the application of fertilisers, by the supply of power to agricultural sector etc. And these are consequences of individual choice as well as policies by the government. Thus 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.
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.
In a market-oriented or capitalist economy, these fundamental problems are solved by the “market”. There is a price, which is influenced by the forces of demand and supply. These forces guide which goods and how much is to be produced and consumed. For example, alu bhujia is produced in the Indian economy because the technology of making alu bhujia is available, the cost of producing and supplying it is not too high and there is demand for alu bhujia. This illustrates how the “what” problem is solved in a market-oriented economy. Suppose that the oil production in the world market declines drastically for some reason. This will increase the price of diesel and petrol world-wide. A taxi company in Ludhiana, which was running 10 taxis, will now wish to convert some of them to CNG (compressed natural gas). In other words, the method of production of taxi service will change. This example illustrates how the “how” problem is solved. As another example, if there is an increase in demand for computer hardware and software by businesses and households, this will push up the demand for services by computer engineers. As a result, their salaries (“prices”) would increase. These
See Ed.Frauenheim, “India Inc.”, TechWeek, September 20, 1999 (also see http://www.techweek.com). This salary figure, stated in US dollars, is $6,000. At the 1999 dollar-rupee exchange rate of $1 = Rs. 43, it becomes Rs. 2.58 lakhs. The source is Economic Survey 2000-2001, Ministry of Finance, Govt. of India, 2001. These are examples of “goods” or “commodities” that have physical dimensions. “Services” refer to tasks being performed for someone, e.g., a hair-cut, education, doctor’s advice etc. “What” problem applies to services as well.
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.
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.
However, no economy in the world is cent per cent centrally planned or market-oriented. If both the private sector (i.e. market forces) and the government play almost equal roles in the functioning of the economy, then such an economy is called a mixed economy. Otherwise, if government or public sector activities are dominant, we call it a centrally planned economy (e.g. the former Soviet Union). If private sector activities are dominant, we call it a market-oriented or a capitalist economy (e.g. United States and Japan). The Indian economy, until the end of the seventies, was a very much a mixed economy. It is still considered a mixed economy today, but since the 1980s has been gradually moving towards a market-oriented economy. It is much less controlled and private firms operate in a much more liberalised environment now, than in 1960s or 1970s. * All Clips are NETs (not for exams and tests).
1.2 PRODUCTION POSSIBILITY CURVE AND OPPORTUNITY COST From a general discussion about economics and how an economy works, we now move to a specific issue and look at it analytically. It sets the tone for the type of economic analysis to come in the following chapters. To begin with, suppose that Mr. Kheti Lal, a farmer in U.P., owns 50 acres of land for cultivation. He can grow wheat or sugar cane or both. Suppose that the production technologies of wheat and sugar cane are such that one acre of land yields 2500 kgs of wheat or 80 tons of sugar cane. How does Mr. Kheti Lal decide how much of land he should use for wheat and how much for sugar cane? A natural way is to first determine the various combinations of wheat and sugar cane that he can grow, given the total land he has and given the technologies of producing wheat and sugar cane. Next, he can select a particular combination, depending on profitability of raising wheat and sugar cane. We are not interested in the latter issue, but only in how much of wheat and sugar cane are feasible for Mr. Kheti Lal to produce. For example, he uses all his land in growing wheat. Then he can produce 125 tons of wheat and zero sugar cane. Instead, if he uses all his land to grow sugar cane, then he get zero wheat and 4,000 tons of sugar cane. There are, obviously, many other possibilities. For instance, he can use 30 acres of land on wheat and 20 acres
on sugar cane, and, this will give him 75 tons of wheat and 1, 600 tons of sugar cane. The important point to note here is that, as long as Mr. Kheti Lal uses all his land resource, which is given, having more of one good implies having less of the other. Interestingly, an economy as whole, whether it is market-oriented or not, faces a similar situation. At any given point of time, the technologies available to produce various goods and services as well as the resources available to an economy (meaning the size of its working population, land, buildings, machinery etc.) are all given. Evidently, an economy cannot produce an unlimited amount of any particular good or service. If all resources are used in producing a single good say, computers, only a given number of computers can be produced. Starting from a given allocation of resources to different sectors of an economy, if more resources go into one particular sector (e.g. the computers), less is available for other sectors. In order to decide which combination of goods serves the economy the best, we have to first identify various combinations that can be available to an economy (like different combinations of wheat and sugar cane Mr. Kheti Lal can grow). This is best illustrated through a concept called the production possibility curve, which will be defined in a moment. Now consider a hypothetical economy, in which two goods can be produced: cricket bats and saris.
there are numerous production possibilities. namely. 75 lakh saris can be produced (within. This is how a production possibility curve (PPC) is normally exhibited.1(a). it can produce.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. and join the line segments.) 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. Not surprisingly. Equivalently. .1 summarises the various production possibilities that are available to the economy. it is defined for a “two-good” economy.INTRODUCTION TO ECONOMICS 7 (Assume that all cricket bats are of the same quality and so are saris. it shows various combinations of the two goods that can be produced with available technologies and with given resources. This is because resources are scarce. 75). Assume that the same resources can produce cricket bats also.) It measures one good along the x-axis and the other on the y-axis. the Table 1. 70) etc. more realistically. less is available for other sectors and they will produce less than before.8 This gives rise to a curve as shown in fig. If we consider an economy in which. not just 6 as in Table 1. suppose that 5 thousand bats can be made. These are two production possibilities and both are rather extreme. 3 thousand cricket bats. say. This is the production possibility curve of our hypothetical economy. all resources are employed in producing cricket bats. you see that as the production of one good increases that of the other falls. Most likely there will be other possibilities which are “intermediate”. (Ignore panel (b) for the moment. then we get a smooth curve as shown in fig. a year). say. As more resources go into one sector and produce more. (0.1(b). Table 1. and. 1. For instance. which are fully and efficiently employed. If. Formally. Let us now plot these possibilities. if the economy is producing 50 lakh saris.1. instead. 1. (1.
assuming that the economy is operating on the curve. say the exact point of operation.8 INTRODUCTORY MICROECONOMICS PPC shows the maximum amount that can be produced of one good. Moreover. an economy cannot operate at any point outside of the PPC. For example. along a PPC. machines or plants are kept idle).1 Marginal Opportunity Cost. Starting from possibility B. Similarly. such as at point H. Go back to Table 1. (see fig. 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. the idea behind it is general and holds for any number of goods. if the production of cricket bats increases by one unit (to 2).2. The economy may not be even operating on the curve. by definition. given the amount produced of the other good. You should realise that. when 3 thousands bats are produced. at the production possibility C. 1. . without further information. It should be clear however that. more production of one good means some sacrifice of the other good.1(b)).g.1 Production Possibility Curve PPC is downward sloping. if there is unemployment (as true for a country like 9 We already know that. 70 – 62 = 8 lakh saris need to be forgone. Hence. 1. at point G.g. The rate of this sacrifice is called the marginal opportunity cost of the expanding good. It only shows the possibilities. we cannot. although PPC is defined in the context of a two-good economy. It illustrates the maximum production capabilities of an economy at a given point of time. then the economy will operate strictly within the PPC. A (a) India) or resources work inefficiently (e. the The concept of “downward sloping” is explained in Appendix 1. e. 1. It depends on preferences and tastes of individuals in the economy.9 Note that the PPC does not show or say which point the economy will actually operate on. the marginal opportunity cost of cricket bats is equal to 8 lakh saris.1.
1. 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. as the production of cricket bats increases. Why does the marginal opportunity cost increase? The economic reason is that. that the PPC will look convex. 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 .2 Increasing marginal opportunity cost implies that the PPC is concave to the origin. you can check. Generally. and. Note that “marginal” means “additional”. instead. suppose that you are a doctor having a private clinic in New Delhi and your annual earnings are Rs.not specific to PPC. 1. We observe that. Table 1. if the marginal opportunity cost were constant. Hence more and more of the other good has to be sacrificed to ensure a unit (given) increase of the former good. as more and more of a good is produced. an important example of this will be studied in Chapter 8. the opportunity cost of a given activity is defined as the value of the next best activity. by constructing an example. so on. You will see repeated use of it in later chapters. Finally.1(b)]. factors producing it become marginally less and less productive. it is a very important notion in economics. As an illustration. and. the marginal opportunity cost were decreasing. Typically however. These numbers are indicated in column (3). Most generally. its marginal opportunity cost increases (from 5 to 8. If. There are two other alternatives to having a clinic in New Delhi. 8 lakhs.1 and lists the marginal opportunity cost of cricket bats. the PPC will be a straight line.INTRODUCTION TO ECONOMICS 9 marginal opportunity cost (per thousand bats) is 12 lakh saris. the marginal opportunity cost of a particular good on the PPC is increasing and therefore the PPC is concave [as shown in fig.2.2 is an expanded version of Table 1. Table 1.2 Opportunity Cost – A More General Concept The concept of opportunity cost is very important and universal . 8 to 12 and so on).
if the technologies progress or if the resources available to an economy (such as different types of equipment. . It will be good idea for you to go through Appendix 1 thoroughly now. So far we have discussed in general what economics is about. If you own a barber shop. 4 lakhs because you forego an income of Rs. and. Over time. Microeconomics deals with the principles behind such choices. if the production of one good goes up.2. called microeconomics and macroeconomics. Out of them. which will be derived from economic considerations. but not exclusively. or you can open a clinic in your home town. 4 lakhs from the second best alternative of working in a government hospital. then the economy can produce more of both goods. 4 lakhs annually. the opportunity cost of (additionally) producing one has to be defined in terms of the only remaining good. how many ice creams and chocolates you are going to buy? These are questions of individual choice. the sizes of unskilled and skilled labour force etc.2 Shift of the PPC 1.10 INTRODUCTORY MICROECONOMICS in New Delhi. if you have not done so already. given your monthly pocket money. earning Rs.2. there are only two goods. and therefore. Then your opportunity cost of having a clinic in New Delhi is Rs. That is. 1. you should not however think that an economy can never produce more of all goods. it has many branches or sub-disciplines. The discipline of economics is vast. which would have generated an annual income of Rs. 1. and analytical concepts like PPC and opportunity cost. to the analysis of scarcity and choice problems facing a single economic unit such as a producer or a consumer. 3 lakhs. such as from AC to FH in fig. Note that. hair-cut. Consider an example of producing a service say.) grow. It may be noted at this point that the following chapters contain many analytical constructs or curves (like PPC). Mumbai. The former refers mostly.3 MICRO VERSUS ECONOMICS MACRO Fig. 1. the PPC can shift to the right. In the context of PPC. the (maximum) production of the other must fall. although a given PPC shows that.3 Shift of the PPC We now return to our discussion of the PPC. 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. there are two core branches.
A modern economy produces millions of different kinds of goods and services. guranteed life-time employment in the government-run industries or businesses provided no incentive to work sincerely or efficiently. employment. The capitalist system has its serious problems too. They do not imply that direct government control over most economic activities in the economy – as in centrally planned economies – is the right solution. Equally or probably more serious is the problem of individual incentives. And a failure to achieve the targeted level of production in one sector will create problems for many other sectors. macro economics deals with the behaviour of aggregates such as real Gross Domestic Product (GDP). are problems of one kind. 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.. a central coordination of activities in all or most of these sectors is bound to fail because of unanticipated events or just human error. the market economy provides an opportunity and incentive for individuals to take risks.. Profit-oriented businesses may disregard the adverse impact of industrial activity on local or global environment. Individual freedom is respected and rewarded definitely more so than in a centrally planned system. * We need not mention NET in every clip. Also. “Work according to one’s ability” remained only an ideal. which is essential for inventions and to voluntarily “work according to one’s ability”. . i. Fluctuations. (a) lack of coordination and (b) lack of individual incentives. inflation etc. as there was little reward for it. but only in selective and discrete ways. On the other hand. Obviously. Even the Chinese economy that used to be centrally planned is moving vigorously towards a market system today. periodic recessions or depressions. the means of achieving them in the former suffers from two inherent flaws. i. This book is designed to cover some basic principles of microeconomics. 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. Such problems call for government restrictions.e.INTRODUCTION TO ECONOMICS 11 On the other hand. improvement of standard of living of people. namely. CLIP 1-2 Capitalism Versus Central Planning* We all know that the Soviet Union – along with its economic system . there is little incentive to discover new or better quality products.broke down in the late 1980s. 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.e.
In a capitalist or market-oriented economy. Define marginal opportunity cost along a PPC.12 INTRODUCTORY MICROECONOMICS SUMMARY l l l l l l l l l Economics is a social science.4 1.2 1. A production possibility curve shifts out due to technological progress or increases in the supply of resources available to an economy or both. There are three central problems facing any economy. The “how” problem refers to the choice of methods of production of goods and services. The “for whom” problem concerns with the distribution of income and wealth. the production possibility curve is concave to the origin. Define the production possibility curve.5 1. Normally.6 1. EXERCISES Section I 1. Economics is concerned with the study of individual and social choice in situations of scarcity. What is microeconomics? What is macroeconomics? . namely.1 1. It is because of increasing marginal opportunity cost.8 What is economics about? Name any two central problems facing an economy. these problems are addressed through the operation of markets. What does increasing marginal opportunity cost along a PPC mean? Define opportunity cost. The “what” problem refers to which goods and services will be produced in an economy and in what quantities.3 1. “what”.7 1. “how” and “for whom”.
Suppose you have to practice question-answers for two subjects: mathematics and social science.000 80. Derive your production possibility schedule and plot it. Explain the central problem of “how” with examples. 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. Explain the central problem of “for whom” with examples.17 Explain how scarcity and choice go together. ‘‘Economics is about making choices in the presence of scarcity.9 1.11 1. while you are not that good in answering such questions in social science: 12 questions per hour.000 Draw the production possibility curve for the example of Mr.INTRODUCTION TO ECONOMICS 13 Section II 1.10 1. What are the central problems of an economy and why do they arise? Explain any two central problems facing an economy.16 1.000 52.) .19 Cell phones (in thousands) 90.18 1. Explain the central problem of “what” with examples. You are very good at answering multiple choice questions in mathematics: 20 questions per hour.000 68.15 1. (The two “goods” here are (i) mathematics questions practised and (ii) social science questions practised.14 1. Calculate the marginal opportunity costs of T-shirts at various combinations.000 10.” Explain.12 1. Kheti Lal in the text.000 34.13 1. The following table summarises its production possibilities. You have 8 hours to study.
24 1.14 INTRODUCTORY MICROECONOMICS 1. Define opportunity cost and explain it with the help of an example.23 1. 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.20 1.30 A country produces two goods: green chilli and sugar.21 1. Section III 1. but not inside. If you would have chosen (A). If you would have chosen (B). 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 . Its production possibilities are shown in the following table. Suppose that you choose the science stream.22 1. Which factors lead to a shift of the PPC? Give two examples of growth of resources.27 1. How will it affect the country’s PPC? Distinguish between microeconomics and macroeconomics.) “Massive unemployment shifts the PPC to the left. You had two other options: the arts stream (A) or the commerce stream (C). offering you Rs. giving you Rs. “An economy always produces on. Plot the PPC in a graph paper and verify that it is concave to the origin.” Defend or refute. you would have expected a career.28 1. What is your opportunity cost of choosing the science stream? (Note: It is only a hypothetical example.” Defend or refute. a PPC.29 Give two examples of under-utilisation of resources. you would have expected a career.26 1.25 1. 4 lakhs annually. 3 lakhs annually.
I I CONSUMER BEHAVIOUR DEMAND AND .U N I T.
a piece of bread.4 Price Elasticity of Demand Final goods and services include things that are consumed by households. Consider a final product such as alu bhujia. in case of final goods and services. Another example is the service of a computer programmer.3 Market Demand Curve 2. Who demands a particular good and who supplies it? This depends on the type of good or service in question. because some members of some households work as computer programmers. households are the 1 2. Who are the suppliers of this service? The households.e.2 Meaning and Determinants of Demand 2. in a marketoriented economy.1 Consumer's Equilibrium 2. e. As opposed to final goods and services. This service is demanded by companies or firms. a haircut. there are “intermediate” goods (or raw materials) that are “consumed” (i. The examples are steel in a bicycle factory. and various automobile components in a Maruti car workshop. households demand them and firms supply them. a bicycle repair job etc. In case of services that are required for production. the central problems of “what”. used up) by businesses.1 As consumers.16 INTRODUCTORY MICROECONOMICS CHAPTER 2 CONSUMER CHOICE AND THE DEMAND CURVE • • • • In Chapter 1 it was stated that. . households are the demanders of alu bhujia and companies like Bikanerwala and Leher are the suppliers.g. “how” and “for whom” are solved through forces of demand and supply for various goods and services. wheat in a flour mill. In summary.
This pattern of marginal utility is called the law of diminishing marginal utility. four or five units and so on. and so on. The next (fourth) unit gives you still less utility. In the same manner we can calculate total utility from consuming three. we first have to learn a few concepts. How should a consumer decide how much of a product to buy? What factors do affect this decision and how? 2. after consuming a certain amount. This chapter deals with households as consumers and their demand for final goods and services. the marginal utility and the total utility obtained from consuming three gol guppas are 18 and 42 +18 = 60 utils respectively.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”. 18 utils. Besides total utility. say. she would not demand it at all. Let the second unit give an additional utility of 22 utils. such decline in the intensity of desire starts with the third gol guppa you consume. Accordingly. there is another important concept called marginal utility. and focus on the question of how much of any particular good a consumer should demand (or buy) at a given point of time. Suppose that if you consume only one gol guppa you derive 20 units of pleasure or utility measured in some units. defined as the utility from the last unit consumed. This is captured by a term called total utility. otherwise. Suppose that. Let this (psychological) 1 unit be called “utils. In order to understand this. Getting on with our story. the teachers can use other popular eatable as example to explain the concept. 14 utils. let the third unit give you utility equal to a number less than 22. It states that. That is. in your case. Thus the marginal utility from consuming one gol guppa is 20 and that from consuming two gol guppas is 22. after consuming a certain amount of a good Incase gol guppa is not known to the children. . regardless of how much you like gol guppa. Suppose that you like gol guppa so much that eating just one increases your appetite for it.CONSUMER CHOICE AND THE DEMAND CURVE 17 suppliers and the fir ms are the demanders. Then. Consider for example your consumption of gol guppa .1 Imagine that you are hungry and have come to your favourite gol guppa vendor. served with tamarind (imli) – water and fillings. You can now notice the relationship that total utility is the sum of marginal utilities. your intensity of desire for gol guppa must fall.1.1 Utility Concepts We begin with the notion that a consumer derives some satisfaction from consuming a product. say. 2.” Thus. the total utility from consuming two gol guppas is 20+ 22 = 42 utils. the total utility from consuming one gol guppa is 20 utils.the mouth-watering small round-shaped puffed puris. defined as the total psychological satisfaction a consumer obtains from consuming a given amount of a particular good.
each additional one can only give you more negative utility. since consuming 10 or more gives you negative marginal utility. this law is very natural and should hold for any product one consumes. the marginal utility from it diminishes as more and more is consumed. 2. When you have already consumed quite a few gol guppas – say 8. Imagine what will happen if you keep gulping more. Suppose that eating the 10th unit makes you vomit! This is obviously not a pleasant experience and should give you negative satisfaction.18 INTRODUCTORY MICROECONOMICS or service.) Table 2. you will eat less than 10 gol guppas. Columns (2) and (3) present the marginal and total utility schedules.1.1 Units Consumed of Gol guppa 0 1 2 3 4 5 6 7 8 9 10 with the 10th unit be -7 utils. (If you are crazy and still eat more. let the utility associated Table 2. In fact it is considered as a fundamental psychological law.2 How many Gol Guppas will you consume or buy? From Table 2. 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 . You will see the critical role of it a little later. and you are very full in your stomach – suppose that the next (9th) unit gives zero utility. it is clear that if you are a rational (not crazy) consumer. That is. the marginal utility of ten gol guppas is -7 utils. Accordingly. If you think about it.1.1 summarises your experience with gol guppa in terms of marginal utility and total utility up to 10 units of consumption. Let us resume our story once again.
but also on the price of gol guppas.CONSUMER CHOICE AND THE DEMAND CURVE 19 were free. we can now understand why this . Because. we can say that. In other words. Suppose that. you pay – and thus sacrifice – Rs. 2 for it. Hence you will buy the first unit. from the second unit. the 5th gol guppa is worth having it since it gives Rs. Having the information on price and marginal utility of a rupee. the marginal utility in terms of rupees is less than the price (you can check this directly). Hence we have found the answer to our query: you will buy 5 or 6 gol guppas. On the other hand. 5. the difference between the total utility in terms of money and your total expenditure on gol guppas (defined as price × quantity purchased) is maximised. 2 per piece. Table 2. 5.50.. We keep on making such comparisons for successive units. The last column gives the difference between these two columns.e. However. this is like the net gain to a consumer..” that is.25) when your gol guppa consumption is either 5 or 6. 22/4 = Rs. defined as total utility divided by the marginal utility of one rupee (equal to 4 utils in this example). It gives you utility worth Rs. we can determine how many gol guppas you will consume. Consider first whether you will buy just one gol guppa. it is 4 utils and let the price of gol guppa be Rs.1). Since the marginal utility of a rupee is 4 utils. 2. you get utility worth Rs. you obtain utility equal to 20 utils (from Table 2. Hence you will buy the second gol guppa also. at any level of consumption beyond 6. which is equal to the price. ice cream.g. for you. 20/4 = Rs. Will you buy it? The answer is that you will be “indifferent. and. you would have consumed 8 or 9 units at which your total utility is at its maximum. which is greater than the price. e. how much a rupee is worth to you in terms of other goods. From consuming only one. 11. while you pay only Rs. Having gone through the example. i. 8/4 = Rs. You would like to know how much utility you could have obtained if you had spent some amount on other items. What happens with the 6 th gol guppa is a bit different. whether or not you buy the 6th unit does not make any difference. For example. chocolate etc. The above comparisons between how much of marginal utility in terms of money you get and the price you pay implies that. 2. its price were zero.75 worth of utility. Column (3) gives your total expenditure or spending on gol guppas. from consuming one gol guppa. you may not wish to consume so many. Its second column gives total utility in terms of money. 11/4 = Rs. Similarly. We now define marginal utility of one rupee as the extra utility when an additional rupee is spent on other available goods in general. exactly how many gol guppas you will eat would depend not only on marginal and total utility from consuming gol guppas. you get utility worth Rs. it is clear that you will not buy (consume) more than 6.2 illustrates this. 2. at either of these two levels of consumption. But as long as you pay something for it. We see that this difference is maximised (equal to Rs.
3 The General Principle From the example just worked out. 2. note that.) 0 2 4 6 8 10 12 14 16 18 20 Difference (Rs. means a position of rest.1. In general. Recall that one of our answers is 6 gol guppas. we can now derive the general principle of consumer’s equilibrium with respect to any particular good.75 24.50 11. Ignoring the other answer for the moment. In this example.20 INTRODUCTORY MICROECONOMICS Table 2. frequently used in economics.25 24. the marginal utility in terms of money (Rs. at this level of consumption. you will rest. attain consumer’s equilibrium – at 5 or 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.25 8.50 15 18.25 11.50 9 10. 2) is equal to price (Rs.75 23 Total Expenditure (Rs.25 10. That is.) 0 5 10.2 Difference between Total Utility in Terms of Money and Total Expenditure Total Utility in terms of money (Rs. 2).25 23.25 24. stop – or.” The word “equilibrium”. . Because you do not want to consume less or more than these quantities.75 6. as economists say.50 21. This is indeed the principle and we can state this in two alternative ways. 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.) 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.
the condition (A) or (B) holds either exactly or approximately. This possibility exists because gol guppas are not perfectly divisible: they cannot be measured continuously like points on a straight line. For example. Sometimes. namely.CONSUMER CHOICE AND THE DEMAND CURVE 21 In particular. tea and coffee. if there is a taste change. and. then a change in the price of tea should affect her consumption of coffee and vice versa.g. it will change the marginal utilities from a product. the price of a product is not the only factor that influences how much a consumer should buy of that product. 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. instead. for example. prices of related goods and income. They are namely. where the principle is not satisfied. It is because. when a good is not perfectly divisible.” Now go back to the example once again and see that the consumer’s equilibrium is also attained at 5 gol guppas. If. However.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. if income changes. This is quite natural. . different amounts can be bought even when the prices of goods and services she consumes remain unchanged. there will be just one level of consumption at which the consumer’s equilibrium is achieved. while our preceding analysis is confined to one good (e. The last three factors just mentioned are called the determinants of demand. the consumer’s equilibrium condition will be fulfilled at some other level of consumption even when there is no change in price. the condition (A) says that the marginal utility of a product in terms of money be equal to its price. as the product price changes. If a person consumes. Moreover. in reality. the ratio of marginal utility to price changes so that the consumer’s equilibrium will occur at a different level of consumption. a consumer buys many goods. a product is perfectly divisible and thus can be measured continuously. Also. for example by weight on a weighing scale. 2 Nothing essential or important is gained by deviating from this assumption. 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. The consumer’s equilibrium analysis with respect to many goods (which is outside our scope) suggests two other factors. this is loosely stated as “marginal utility is equal to price.2 2. with condition (A) [or (B)] met. The only modification is that. gol guppa).
2. for a particular family. Moreover. family income and tastes are kept fixed at some pre-determined levels. hold the other factors constant and ask how the quantity demanded of a product changes as its own price changes. If you are a rational consumer. Consider an essential product. Suppose that. The demand curve corresponding to the demand schedule in Table 2. 3 The law of demand in tabular form is called a demand schedule. It is assumed that the prices of related goods. income and tastes. Why is the Demand Curve Downward Sloping? Isn’t it obvious that the demand curve is downward sloping? That is. “Other things” refer to the prices of related goods. say.1. ..1 Own Price: The Law of Demand To isolate its effect.) 12 13 14 15 16 17 A Demand Schedule Quantity Demanded of Apples 24 17 12 9 7 6 quantity demanded. within a month. there may be other determinants of demand for a good. We see that the demand curve is downward sloping. future price expectation. but also due to advertising of products. e. 2. as the own price of a commodity increases. The left column lists various prices. You would then anticipate that supply interruptions would occur and prices of these commodities would skyrocket. It typically measures own price along the y-axis and quantity demanded on the x-axis. It states that other things remaining unchanged.g. you would buy more of these commodities now (and store them) even if prices.3 lists its quantities demanded of apples at different prices. (b) and (c). we obtain a demand curve. income or tastes do not change. (b) income and (c) tastes.22 INTRODUCTORY MICROECONOMICS (a) prices of related goods.2.3 is shown in fig. the quantity demanded of it by a consumer falls. 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. edible oil or sugar. as Apart from (a). It is because an increase in the own price lowers the Table 2. which are consistent with its consumer’s equilibrium. The answer is summarised as what is called the Law of Demand. Each point of the demand curve shows the quantity demanded that is consistent with consumer’s equilibrium.3 Own Price (in Rs. Suppose there is a weather prediction that your village or town will be hit by a severe cyclone in the next three days. while the right column lists the corresponding quantities demanded. If we graph a demand schedule. taste changes can occur not only because of natural changes in a person’s liking.
4 Consider Table 2. An intuitive way to see this is that. 3) will be on the demand curve too.CONSUMER CHOICE AND THE DEMAND CURVE 23 Table 2. it is not. Assume further. for simplicity. a consumer buys more of it. This means that the marginal utility curve itself is the demand curve. the quantity demanded of a product falls. as a consumer buys more of a good. The quantity demanded of T-shirts is 7 when the price is Rs. Indeed.4. that the marginal utility of a rupee is equal to 1 util. that is. suppose that the price of a T -shirt is Rs. The consumer’s equilibrium condition now holds at 3 T-shirts consumed. Hence the pair (65. Similarly. Interestingly. her marginal utility decreases and therefore she is willing to pay less per unit. and. the quantity demanded is 3. Thus the pair (45. the demand curve is downward sloping because of the law of diminishing marginal utility. The consumer’s equilibrium condition holds at 7 T-shirts consumed. There is a reason behind it. Mark that. which lists the marginal utility from consuming T-shirts. we can determine that all other points on the marginal utility schedule are points on the demand schedule. the law of diminishing marginal utility. 7) will be on the demand curve.1 Demand Curve Corresponding to Table 2. again for simplicity of exposition. 45. 2. namely. Then. the demand curve is essentially the marginal utility curve. 45. This can be turned around to say that if the price of a product falls. This can 4 be restated as follows. Likewise. suppose that the price of T -shirts increases to Rs. . diminishing marginal utility sets in with the very first unit of consumption. at price Rs. our consumer’s equilibrium condition (A) can be stated as “Marginal Utility = Price.4 Marginal Utility Schedule and the Demand Schedule Quantity of T-shirts 1 2 3 Fig.” To begin with. 65. 65.3 Marginal Utility of T-shirts 75 70 65 60 55 50 45 4 5 6 7 the own price increases.
The same should happen to the demand for tea if the price of coffee rises or vice versa. 200 20 11 5 2 1 Quantity Demanded of Tea when Price of Coffee (per kg) = Rs. which will reduce the demand for sugar. In other words. How will this affect Mrs. the quantity demanded of tea is 18. Das’s demand for gulab jamun? It will increase. 250. 5 a piece to Rs. 250. In Table 2. 150 170 190 210 230 . Another example of a pair of complementary products is petrol and cars. 170. Consider another example: that of tea and coffee. 250 28 18 10 7 4 Price of Tea (per kg) Rs. Suppose that burfis become more expensive: from Rs. at tea price equal to Rs. because burfi and gulab jamun are substitutes of each other in consumption.2. Das.5 and 2. 200 to Rs.5 in consumption. On the other hand. the quantity demanded of cars should fall.5. These examples illustrate cross price effects: how the demand for one particular product is affected by a change in the price of another. 8 a piece. who lives next door to you. given coffee price = Rs. the quantity demanded of tea should fall. For example. If the price of petrol rises. or. 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. Change in Price of a Related Good Suppose that Mrs. Burfi and gulab jamun are her favourites. 200. whereas. Thus. 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. because tea and coffee are also substitutes. the quantity demanded of tea is 11. consider tea and sugar. Numerical examples of cross price effects are given in Tables 2. Why. Sugar is complementary to tea Table 2. if the price of tea goes up. has a weakness for sweets. 170). note that as the price of coffee rises from Rs.2 Determinants of Demand Now turn to the remaining factors that affect the quantity demanded of a particular product.6. the quantity demanded of tea increases for any given price of tea.24 INTRODUCTORY MICROECONOMICS 2. what we have called the determinants of demand. given price of coffee = Rs. at the same tea price (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.
5 are graphed in Figure 2. Ice cream is your favourite but it is costly. in Table 2. The demand curve for sugar when tea price is Rs.CONSUMER CHOICE AND THE DEMAND CURVE 25 Table 2. 5 8 11 14 17 tea given in column (2) and (3) of Table 2. which is your favourite. 200 lies to the left of that when the sugar price is Rs.2 Change in demand due to increase in the price of a substitute good they are cheap. 250 lies to the right of that when the price of coffee is Rs. but Fig. 200 12 7 4 2 1 Price of Sugar (per kg) Rs. Hence. as the tea price increases from Rs. We see that demand curve for tea when the price of coffee is Rs. A Change in Income Suppose that you only buy peanuts and ice cream from your pocket money.6. the quantity demanded of sugar decreases for any given price of sugar. Very likely. Will you buy more of ice cream.2.3 graphs Table 2.6. 2. Thus. Figure 2. generally. You like peanuts much less. 200. Hence. not because your taste changes but because you can afford more ice cream. we can say that. 200. Similarly. you will buy less of peanuts. an increase (a decrease) in the price of a complementary good shifts the demand curve for a product to the left (right). Whether you will buy more peanuts is not clear. 170. 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. 170 20 14 9 6 5 Quantity Demanded of Sugar when Price of Tea (per kg)= Rs. notice that. as income increases. 170 to Rs. more of peanuts or both? We bet that you will buy more ice cream.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. a consumer may .
then we say that the product in question is a normal those. For the inferior good. as income increases.26 INTRODUCTORY MICROECONOMICS buy more or less of a product. 400. 2. The original demand curve for the normal good.4. 300.4 and 2. These are graphed in figs. 400 15 12 9 7 5 3 19 16 13 11 9 7 1 2 3 4 5 6 . 2. ice cream). peanuts). is marked by NN 1 that represents the column pair (1)-(3). when income is Rs. nor mal goods are those. for which demand falls as income rises. Inferior goods are Table 2. Observe that. quantity demanded of the normal good increases (by comparing columns (2)-(3)) and that of the inferior good decreases (by comparing columns (5)-(6)). for which demand increases as income increases. Table 2. This represents the column pair (1)-(2). If she buys less (e.7 presents numerical examples of both normal and inferior goods. If she buys more (e. then we say that it is an inferior good. The new demand curve. is indicated by the line NN0 in fig. 2. when income of Rs.3 Change in demand due to increase in the price of a complementary good good. Hence an increase in income shifts the demand curve to the right if the good is nor mal.g.g.5. Put differently.7 Own Price Normal and Inferior Goods An Inferior Good Own Price Quantity Quantity Demanded: Demanded: Income = Income = Rs. 300 Rs. 300 Rs. the demand curves are indicated by FF 0 (original) and FF 1 (new) in Fig. 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. at any given price.
) constitute an inferior good. for health reasons. A change in the own price causes a movement along a given demand curve: higher (lower) the price. 2.3 Change in Quantity Demanded Versus Change/ Shift in Demand We have seen that the quantity demanded of a product depends on own price and “other” factors like prices of related goods. Fig. or. this is also considered a taste change. If. Thus an increase in income shifts the demand curve to the left if the good is inferior. A graphical representation of this is the demand curve.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). maize and related cereals. there are much fewer examples of inferior goods than normal goods. We can then say Fig. 2. cereals as a single category of goods (that includes rice. in which your favourite actor drinks Coca Cola.2. Suppose you are impressed by an advertisement in TV. for instance.4 Change in demand due to increase in income (Normal Good) . less (more) is the quantity demanded. bajra. This will shift your demand curve for Coca Cola to the right. the inferior-good characteristic applies to bajra. wheat. In India. An unfavourable change in taste will imply the opposite. A taste change may result from a change in a person’s liking. The law of demand refers to the effect of a change in the own price. jowar etc. income and tastes. as a result. from some other source. Yet there are important examples. 2.CONSUMER CHOICE AND THE DEMAND CURVE 27 fig. In the real world. 2. This is an example of a “favourable” change in tastes.5. jowar. your liking for Coca Cola increases. and. you have to consume more of a product although you don’t like it. A Change in Tastes Finally. which is downward sloping. Within this category. consider a taste change.
2. 19) is a point on the market demand curve. 3 a piece. Suppose that there are three consumers in the market: Amar. e. There is a price change from P0 to P1. Plot the points.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. there is a movement along the same demand curve from A to B. Hence (a) Change in Quantity Demanded (b) Change in Demand Fig. (1)-(3) and (1)-(4).8. Amar demands 5. then the total quantity demanded is 19.6 Change in Quantity Demanded Versus Change in Demand (3. 2.6(a) illustrates a change in the quantity demanded. fig. gulab jamun. In contrast. the economy of a region or a country? The economy-wide demand curve for a particular product is called the market demand curve. The distinction between the two concepts is illustrated in fig. Fig. Consider the market for. 2. If at the price equal to Rs. How do we get the demand curve of a product by all individuals together in an economy. income or tastes.g.6. meaning a shift of a demand curve from DD0 to DD1 due to a change in the prices of related goods. The column . 2. Individual demand schedules are given by column pairs (1)-(2). Akbar and Anthony.6(b) shows a change in demand. The quantity demanded changes from Q0 to Q1. Repeat the same exercise for other possible prices and obtain the corresponding points. we call this a change in demand. 2. It is obtained by summing up the demand curves across consumers or households.. say. when a change in any other factor causes a (left or rightward) shift of a demand curve. Akbar 6 and Anthony 8 per week. In contrast. A numerical example is given in Table 2. As a result. join them and you get the market demand curve.28 INTRODUCTORY MICROECONOMICS Such a movement is called a change in the quantity demanded.
the price elasticity of demand quantifies the effect of a change in own price on the quantity demanded. (3) and (4). For example. The concept of elasticity captures the magnitude of change or the degree of responsiveness. Note that for each row (price). the distribution of income. 2.5 2. 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. the entry in column (5) is the sum of corresponding entries in columns (2).4 PRICE ELASTICITY DEMAND OF We have seen how various factors like own price and income affect the demand for a commodity.7. the market size. that is. These individual demand schedules and the market demand schedule are graphed in fig.8 what we can call. The direction of change was our focus . 1 2 3 4 5 6 5 Many multinational firms today look at the Indian or the Chinese market as very lucrative. or what we can call. (c) consumers’ tastes (d) the number of consumers who buy the product. which refer to the huge number of consumers in these countries. 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. or Table 2.whether the quantity demanded increases or decreases as price. (a) prices of related goods. Akbar’s and Anthony’s demand curves are respectively marked by their names. Amar’s. (b) income levels across individuals. because of their market sizes. . income or other factors change.CONSUMER CHOICE AND THE DEMAND CURVE 29 pair (1)-(5) gives the market demand schedule. The right most line is the market demand curve. This is obtained by horizontally summing the individual demand curves.
But there is no reason to get confused. we can also write (E ) eD = − ∆Q/Q0 . Suppose that the price increases to P 1 and the quantity demanded falls to Q1. except for the “minus” sign. Some other textbooks define the price elasticity the same way as above.30 INTRODUCTORY MICROECONOMICS Fig. 2. let the original price be P0 and the original quantity be Q0. our definition gives the absolute value of the elasticity. which is. the ratio of % change in quantity demanded and that in the own price is negative in sign. rasgoolas were being available at Rs.4. (P1 − P0 ) / P0 If we further denote a change in quantity as ∆Q and a change in price as ∆P. Strictly speaking.1 Definition and Formulas Formally. Then the % changes in price and quantity demanded are respectively equal to [(P1–P0)/P0]×100 and [(Q1–Q0)/Q0]×100. ∆P / P0 Consider the following numerical example. Along a given demand curve. Thus (C) can be written as (D ) e D = − (Q1 − Q0 ) / Q0 . Hence attaching a negative sign in front of the ratio makes the sign of eD positive. 5. 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. often. referred to as “elasticity”. Suppose that in your home town.7 Individual and Market Demand Curves 2.00 per piece and the residents of .
and. equal to D0. It is because any percentage change of a variable is independent of units.00)/5. Suppose that the people in the town are now buying 960 rasgoolas per day. jewellery).50 per piece.8. the elasticity associated with the flatter demand curve is higher. while the % change in price is the same along both demand curves. Hence. The % change in quantity is equal to [(960 – 1200)/1200] ×100 = – 20. P0 is the price of the product.00] ×100 =10. At this point. Finally. we say that the product demand is inelastic. If two demand curves intersect. the % change in quantity demanded is less than that of the price. and. is equal to 20/10 = 2.8 Elasticity Comparison .g. This implies that. the demand for luxury goods is elastic and that for necessary goods (e. it is said that the demand is unitarily elastic. at price P0.CONSUMER CHOICE AND THE DEMAND CURVE 31 the town were buying 1200 rasgoolas per day. Why? Because the original quantity demanded is the same. at Rs. eD. The % change in the price is equal to [(5. In this special case. Properties 1.50 – 5. say to P1. This is exhibited in fig. Fewer people are eating rasgoolas and many who eat. 2.g. basic food items) is inelastic. if eD =1. the price elasticity. The claim is that. along both demand curves. We then say that the product demand is elastic (e. the % change in quantity demanded is greater along DD´. Therefore. the quantity demanded falls more along the flatter demand curve (by amount D2D0 as compared to D1D0 along DD). if eD>1. greater is the degree of responsiveness of quantity demanded to price. at their point of intersection. In particular. 3. The demand curves DD and DD´ intersect at the point C. Now they become more expensive for some reason. Typically. are eating less. 2. Higher the value of the price elasticity. 5. price elasticity associated with DD´ is higher. A very desirable property of the elasticity formula in measuring the degree of responsiveness is that it is independent of the choice of units. then the % change in quantity demanded must exceed the % change in price. 2. if there is an increase in price. the elasticity is greater along the flatter demand curve DD´. What is the price elasticity of demand? We have to do some arithmetic. If eD<1. the demand curve takes a particular Fig.
2.. 2. its price elasticity of demand is likely to be high. like demand for a rare medicine or some very bad case of addiction to undesirable products like opium. because. where demand curve is horizontal and thus the demand is perfectly elastic. which extends towards the x-axis and y-axis in a uniform manner without touching them. The last special case is the one. the magnitude of price elasticity depends on the following factors.e. Fig. i. Availability of Close Substitutes: If close substitutes of a product are readily available. 2. (b) Perfectly Elastic Demand Fig. the price 2. This case is exhibited in fig.2 Factors Affecting the Magnitude of Price Elasticity In general. 4. the quantity demanded is totally insensitive to any change in price.9 exhibits this.10(b) shows this. 2. This is evident. If the product is absolutely essential. ∞ . along a vertical demand curve. An economic example of this demand curve will be given in Chapter 4.10 Elasticitiy = 0. the price elasticity is zero. called rectangular hyperbola in geometry.32 INTRODUCTORY MICROECONOMICS shape.. 2.4. the product demand is totally or perfectly inelastic.10(a).9 Unitarily Elastic Demand elasticity is equal to infinity. It is a curve. Fig. In this case. the demand curve is vertical. i.e. There are two other special cases. because even a very small increase in price will make consumers switch to other (a) Perfectly Inelastic Demand Fig.
the whole world was shocked.CONSUMER CHOICE AND THE DEMAND CURVE 33 products in a big way. 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 consumption of petrol is a prime example. the demand for opium is very inelastic. rice in Orissa or West Bengal. therefore. On the other hand. if it is a staple food item of a particular region. Hence his demand for five- star restaurant food is inelastic. more elastic is the demand for any product. 2. A form of consumption such as eating out in fivestar restaurants is a luxury for many people. The demand for salt is an example. because he is already habituated. But over years alternative types of energy were developed. then the price elasticity is likely to be small. But. Hence the demand for these items is likely to be relatively elastic.11. Similarly. In other words. the demand for essential products is likely to be inelastic.3 Measurement of Elasticity Finding price elasticity of demand using its definition as such is called the percentage method of measuring elasticity. there are no (very) close substitutes available. it may be an essential demand. and. Countries could not immediately find and adopt any other forms of energy for their needs. In particular. if it is a high-price item and takes a major portion of your total expenditure. Hence the demand for rice is likely to be inelastic. substitutes became more readily available. More generally. for an opium addict.4. 2. The demand for oil is more elastic today than it was 30 years ago. in the absence of close substitutes. for someone who is very rich. On the other hand. as shown in fig. It is indispensable. say. having intercepts A and B respectively on the price axis and quantity axis . your demand for it is more sensitive to a price change. the longer the time period. their demand for it is very elastic. Habits: Some products which are not essential for some individuals are essential for others. Suppose that it is a straight-line demand curve. the elasticity is likely to be small. substitutes of oil could not be available and the demand for oil was very inelastic. “luxury” items like eating in a restaurant. the elasticity of demand is likely to be high. In the 1970s. are relatively dispensable. whereas for other casual opium takers. Clip 2-1 reports price elasticities for various products that have been estimated by various authors. by definition. when OPEC (Organisation of Petroleum Exporting Countries) dramatically increased the price of oil for the first time in history. when the price change is very small. buying a big-size colour TV etc. Otherwise. the demand is likely to be elastic. For example. that is. Time Period: All other things remaining the same. a graphical formula or a geometric method can also be used to measure elasticity.
3.” Journal of International Development. Note that item No. “Regional Differences in India’s Food Expenditure Pattern: A Complete Demand Systems Approach. 1.) Price Elasticity Estimate 0. and R. Gyourko. It indicates that long-distance telephone calls are not a “luxury” demand anymore. they have become a necessity in a country like India.” mimeo. J. The item no. “Demand for Telephone Usage in India.64. 1999.560 0. and P. 5 shows that the demand for residential land in America is elastic. equal to 1. V. P. Wharton School of Management.544 Source Meenakshi and Ray (1999) Meenakshi and Ray (1999) Meenakshi and Ray (1999) Das and Srinivasan (1999) 2. as these are essential items. The elasticity for this item is also less than one.A. 4 is an example of a service: long distance phone calls from PCOs. Product/Service 1. the price elasticities for food items and clothing are less than one. 2001.S. Meenakshi. Voith.V. . 11. 1999.” Information Economics and Policy. Cereals & cereal substitutes (India) Other foods (India) Clothing (India) Long distance phone calls from Public Call Offices (India) Residential Land in Philadelphia (U.580 5. 0. Five examples are reported below.804 0. pages 47-74. and Ranjan Ray. “The Price Elasticity of Demand for Residential Land: Estimation and Some Implications for Urban Reform. four of which are for India and one for America. Srinivasan.640 Gyourko and Voith (2001) Das.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. pages 177-194. 11. As you see. J. 4.
7.50 and quantity = 960. the total expenditure on a particular good = price × quantity. hence TE was equal to Rs.00 and 1. If we denote total expenditure by TE.280. This graphical formula is called point elasticity. Suppose that initially the price is P0. price by P and quantity by Q. The point elasticity formula implies that. At the new price Rs. the price elasticity turns out to be equal to BC/AC. That is.200. as price increases. Thus the total expenditure has fallen. 2. P and Q were respectively Rs. . TE = Rs. In other words. Then. at a certain point along a straight-line demand curve. You will find a treatment of this in a higher-level micro economics textbook.4. it also indicates the direction in which the total expenditure on a product changes. At point B the elasticity is zero and at point A it is infinity. 5. It may not hold when the demand curve is not a straight line.6. 5. 6 7 8 This is not a general property of price elasticity. If it is not a straight-line demand curve. and the quantity consumed is Q0.8 2. as there is a change in price. A proof of it is given in Appendix 2.CONSUMER CHOICE AND THE DEMAND CURVE 35 respectively. Originally. Note also that the elasticity is equal to 2. 6. in the example. is equal to the lower segment divided by the upper segment of the demand curve at that point. Let us now calculate TE. does consumer spending or total expenditure on rasgoolas increase or decrease? By definition. that is. 5. then the point elasticity measure at a point on it is based on the tangent to the curve at that point. the total expenditure falls. then TE = PQ. the consumer is at point C on the demand curve. the demand for rasgoola is elastic. Return to the rasgoola example and ask the following simple question.000. 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. point elasticity. and. Because of the increase in the price of Fig. as there is a price increase.11 Point Elasticity along a Straight Line Demand Curve rasgoolas. for small price changes.2 Total Expenditure and Price Elasticity The concept of price elasticity does not just quantify the relationship between price and quantity demanded.
If the product demand is elastic. If the demand for a product is elastic. but always. unitarily elastic or inelastic.9 presents this result in a tabular form. an increase in price leads respectively to a decrease. Table 2. Just the opposite holds when the product demand is inelastic. not just in this example. 2. In this case a large price change leads only to a relatively small adjustment in quantity. then the total expenditure does not change with any price change. Hence the total expenditure must change in the same direction in which the quantity changes. as price increases. i.9. You can relate the last case to fig. but it is beyond our Table 2. depending on the magnitude of price elasticity. Alternatively. it means that a small price change invites a relatively large adjustment in the quantity. the total expenditure always increases as price increases. when the product demand is elastic. we can infer whether the product demand is elastic or inelastic.e. There is thus a general relationship between the direction of price change and the direction of change in total expenditure. as a special case. 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 . quantity falls and the fall in quantity is associated with a fall in the total expenditure. if the product demand is inelastic.36 INTRODUCTORY MICROECONOMICS It turns out that such opposite movements in the directions of price and total expenditure changes hold. if the product demand is unitarily elastic.. Moreover. which depicts the unitarily-elastic case.9 scope. given the direction of change in the price and given whether the product is elastic or inelastic. no change or an increase in the total expenditure on the product. Hence the total expenditure must change in the same direction as the price change. it is quite intuitive. a price increase leads to an increase in total expenditure. This result can be proven algebraically. if we know the direction of change in price and the direction of change in total expenditure. So far we have discussed how we can determine the direction of change in total expenditure. That is. Similarly. However. Now you see that. the total expenditures at all points on that demand curve are the same.
You can readily verify that from Table 2. Return once again to the rasgoola example. the demand curve shifts to the right or left. depending on whether the good is normal or inferior. via price elasticity. The demand curve is downward sloping because of the law of diminishing marginal utility. the demand for a product increases or decreases. the total value of sales is usually called total revenue and note that total revenue is equal to the total expenditure by the consumers. l 9 We will see the use of the term “total revenue” in Chapters 4. Consumer’s equilibrium is attained when the condition that the marginal utility in terms of money is equal to the price is met. the total expenditure increases.CONSUMER CHOICE AND THE DEMAND CURVE 37 instance. then the product demand must be inelastic. wouldn’t you want to know if a price increase would increase or decrease your total sales in rupees? From a seller’s perspective.e. a change in income or a change in tastes. This link. The law of demand defines demand curve. . 6 and 7. The demand curve is essentially same as the downward sloping portion of the marginal utility curve. between changes in price and total expenditure has important practical implications. the difference between total utility in terms of money and the total expenditure on a good is maximised. If you are the halwai shop owner and are thinking about increasing the price of rasgoola. i.9 Hence the relationships between elasticity. 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. if because of a price increase. price change and total expenditure are important from the viewpoint of decision making by a producer or a firm. 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.. An increase in the price of a substitute good causes an increase in demand or a rightward shift of the demand curve. At the consumer’s equilibrium.9. Suppose that there is only one (giant) halwai shop in town. As income increases. A shift of the demand curve is caused by a change in the prices of related goods. who sells rasgoolas.
the point elasticity is equal to the lower segment divided by upper segment of the demand curve at that point. When two demand curves intersect. an increase in the price of the product leads to a decrease (an increase) in the total expenditure on the product. shifts the demand curve to the right. In case of elasticity equal to one. Given that the demand is a straight line. the demand for luxury products is elastic and that for necessary goods is inelastic. l l l l l l l l l l l l EXERCISES Section I 2. the higher is the price elasticity of demand for a product. The price elasticity of demand is independent of the choice of units. In case of a unitarily elastic demand. the elasticity associated with the flatter demand curve is greater. The determinants of market demand curve are prices of related goods.1 2. Market demand curve is obtained by horizontally summing up the individual demand curves. If demand is elastic (inelastic). a change in price leaves the total expenditure on the product unchanged. the price elasticity is zero (infinity). an unfavourable change does the opposite. Typically. the more elastic is the demand for a product. tastes and the market size. Longer the time horizon.38 INTRODUCTORY MICROECONOMICS l A favourable taste change increases the demand for a good. Define marginal utility. i.e. Greater is the share of the total budget spent on a particular good. the more elastic is the demand for it. Greater the availability of close substitutes of a product. the demand curve is a rectangular hyperbola. If the demand curve is vertical (horizontal)..2 Define total utility. distribution of income. .
9 2.10 2. Give the meaning of demand. Give an example of a pair of commodities such that one of them is complementary in consumption to the other.16 Total Utility 0 10 25 38 48 55 A person’s marginal utility schedule is given below.15 A person’s total utility schedule is given below. Derive her marginal utility schedule.7 2.8 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.5 2.13 2. If the price of good X rises and it leads to an increase in demand for good Y.3 2. how are the two goods related? Define price elasticity of demand. Derive her total utility schedule. Name two determinants of the demand.14 How is total utility derived from marginal utilities? State the law of diminishing marginal utility.) .12 2. Section II 2.6 2. Amount Consumed 0 1 2 3 4 5 2.CONSUMER CHOICE AND THE DEMAND CURVE 39 2. 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. List the factors that cause changes in demand.4 2. (Assume that the total utility of consuming zero is zero.11 2.
the marginal utility of one rupee is 3.22 2. 30.17 2. has already eaten 3. Suppose further that. Starting from an initial situation of consumer’s equilibrium. 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.29 2.28 2.24 2.31 What is consumer’s equilibrium. 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. Should she eat more ice cream or should she stop? Explain the determinants of demand. How does an increase in income affect the demand curve for a normal good? . Lakhmi.25 2.21 2.26 2. 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.30 2. for her.20 2. State the condition of consumer’s equilibrium.40 INTRODUCTORY MICROECONOMICS Amount Consumed 1 2 3 4 5 6 2.27 2. What is meant by cross price effects? Give two numerical examples to illustrate this. 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. Her marginal utility from eating 3 ice creams is 90. suppose that the marginal utility of a rupee increases.18 2.19 Marginal Utility 7 10 8 6 3 0 2. who loves ice cream.23 2. Will it increase or decrease the quantity demanded of the product? Ice creams sell for Rs.
Ifraah. .41 Explain the determinants of the market demand curve.32 2. How is the market demand curve derived from the individual demand curves? There are four consumers of a fruit called Smile. Originally. 14 and as a result the quantity demanded changes to 500 units. a particular brand of lipstick. They are Isha. medicine.34 2.CONSUMER CHOICE AND THE DEMAND CURVE 41 2.38 2. Distinguish between individual and market demand curves.40 2. Draw diagrams showing elasticity equal to (a) zero. Which of the following commodities have inelastic demand? Salt. (b) one and (c) infinity. Their demand curves for Smile are given below. a product was selling for Rs. 10 and the quantity demanded was 1000 units.35 2. Derive the market demand curve. The product price changes to Rs. (b) substitute goods. Calculate the price elasticity.36 How does an increase in income affect the demand curve for an inferior good? Define (a) complementary goods.37 2. Distinguish between a change in quantity demanded and a change in demand.) Demanded by Isha 1 2 3 4 5 6 16 11 7 4 2 1 2. 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. (c) inferior good and (d) normal good.33 2.39 2. Ila and Ibema.
45 2. B and C. 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. but the total revenue is now Rs. Compare the point elasticities between the points A.43 2.250.49 2. 30. As a result.50 Draw a straight line demand curve. 350. 300 for a standard cleaning job and per month it used to generate total revenue equal to Rs. She has since last month increased the price of dental cleaning to Rs. the number of peanut packets demanded falls by 8%. Choose any three points on it and compare the point elasticities at these three points.42 INTRODUCTORY MICROECONOMICS 2.47 2.44 2. A dentist was charging Rs. What is the elasticity of demand for peanut packets? As the price of a product decreases by 7%. The % change in quantity is 4. what can we conclude about the elasticity of demand for such a dental service? .48 2. 33. What is the % change in price? As the price of peanut packets increases by 5%. Find the % change in quantity. fewer customers are now coming for dental cleaning. 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%. From this. The price elasticity is 0.5%.42 2.5. The % change in price is equal to 5. The price elasticity is 2.000.46 2. the total expenditure on it has gone up by 3. Consider the above straight line demand curve.
” Defend or refute. (a) A new steel plant comes up in Jharkhand. Their demand schedules are given in the following table. a family’s spending on the product has to increase.52 “If a product price increases. 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. Explain why consumer’s equilibrium is attained when the marginal utility of a product in terms of money is equal to its price. Suppose that the train fare between the two cities comes down.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 .53 Discuss how the market demand curve is derived from the individual demand curves and the determinants of market demand. 2. Suppose there are three consumers in a particular market: Leander. How will this affect the demand curve for bus travel between the two cities? Section III 2. Many people who were previously unemployed in the area are now employed. If the Indian Airlines reduces the air fare to Goa. Determine how the following changes (or shifts) will affect market demand curve for a product.54 2.CONSUMER CHOICE AND THE DEMAND CURVE 43 2.51 2. Chennai. Andre and Tim. the Government of India suggests Indian Airlines to reduce air fare to Goa from the four major cities. Mumbai and New Delhi. Kolkata. 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.
joins the market. Why does the demand curve slope downwards? Explain the factors affecting the magnitude of price elasticity of demand. . whose quantity demanded at any given price is half of that of Leander. Marat. (c) Suppose Andre stays in the market and another person.57 (a) Derive the market demand schedule and plot the market demand curve.44 INTRODUCTORY MICROECONOMICS 2.56 2. (b) Suppose Andre drops out of the market. Derive the new market demand curve. Derive the new market demand curve.
I I I PRODUCER BEHAVIOUR AND SUPPLY .PRODUCTION AND COSTS 45 U N I T.
3. . that is. we will use the term “profit” or “profits”. Then your profit is equal to Rs.1 By definition. profit earned by a firm is equal to its total revenues minus the total costs. 20 × 500 = Rs.500. Producing hammers requires inputs such as labour.2 Costs In Chapter 2 we studied the consumer’s behaviour.500. In this chapter in particular. Both are correct uses. In turn. suppose that you are in the business of making hammers.000. They are selling at the price of Rs. 6.000 – Rs. A producer or a firm is in business to maximise profit. The sum total of payments to all inputs is the total cost of production. Then the total revenues generated are equal to price × quantity. inputs have to be paid. 6. building. and. you produce and sell 500 hammers. 1 In this chapter and others. equipment and raw materials.46 INTRODUCTORY MICROECONOMICS CHAPTER 3 AND PRODUCTION COSTS • • 3. Let the total cost of making 500 hammers over the month be Rs. This is a technological relationship. 20 each. we study important concepts associated with production and costs.500 = Rs. 10. 10. As an example.1 Production 3. during a month. In Chapters 3 and 4 we will be concerned with the producer’s behaviour. Rs.
In Section 3. a firm employs only two factors or inputs.1 PRODUCTION 3. Table 3.1.1. say. the employment of inputs leads to their payments. 3.1 Linkages These linkages are depicted in fig. we will analyse that between output and payments to inputs. what is called output. or. which is called production function (to be defined in a moment). defined as a technological relationship that tells the maximum output producible from various combinations of inputs. and.PRODUCTION AND COSTS 47 The above example is illustrative of some important linkages. we will study the relationship between inputs and Table 3.1 Production Function Labour (in hours) A B C D E F G H 0 1 2 3 4 5 6 7 Land (in acres) 0 2 4 6 8 10 12 14 Output (in units) 0 5 11 18 24 30 35 40 .1. On one hand. and. 3. 2 hours of labour and 4 acres of land produce at the most Fig. The link between output and revenues will be examined in Chapter 4 (and in Chapter 6 also). labour (measured in hours) and land (in acres). For instance. output.1 lists some factor combinations and the corresponding output levels. is linked to total revenues in the product market. 1 hour of labour and 2 acres of land produce at the most 5 units output. output is linked to inputs via technology. This chain links output to costs.2. On the other hand.1 Production Function The most basic concept here is what is called the production function. In section 3. the amount produced. 3.
These are respectively similar to the concepts of total utility and marginal utility discussed in Chapter 2.4 When the employment of an input changes. we can differentiate between unskilled labour and skilled labour. APP = TPP/L.48 INTRODUCTORY MICROECONOMICS 11 units of output. instead of “maximum” output.1..2 Returns to an Input A production function given in the tabular form such as in Table 3. There can be other inputs like capital.2.3 3. raw material etc. 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.2 Note that the notion of production function is not just confined to two inputs. we define Average Product or Average Physical Product (APP) as the TPP per unit employment of the variable input. Finally. Table 3. marginal and average returns to an input. Three concepts arise in this experiment. is called labour. The next one is marginal product or marginal physical product (MPP). L. where the variable input. not all. It simply defines the total output at a particular level of employment of an input when the employment of all other inputs is unchanged.. One is total product or total physical product. e. i. denoted by TPP. possible combinations of inputs and output. These are also respectively called total. It is normally assumed that inputs work to the best of their efficiency. Also. we just say output. If we graph a TPP schedule. . we call it a variable input.e.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. we get a total physical product curve.g. A reasonable way to assess this will be to vary the employment of one input while keeping the employment of other inputs fixed. and so on. where L is the level of employment of the variable input.1 gives only some. 2 hours of labour combined with 4 acres of land produce 11 units of output. A numerical example showing a TPP schedule is given in Table 3.1 does not reveal much about the contribution of a single factor towards production. Hence.
2. the APP schedule. Fig.2 The Total Physical Product Curve Corresponding to Table 3. which is 12. is derived from the total physical product. Likewise. MPP and APP are applicable to The marginal physical product. These graphs corresponding to Table 3.2 is given in column (2) of Table 3. 3. 3.33 8 6 4 Labour Hours employed (L) 0 1 2 3 4 5 6 7 8 9 .2 the MPP at L = 2.3 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. MPP. For instance. and TPP at L = 1. The graphs of an MPP schedule and an APP schedule are respectively called the marginal physical product curve and the average physical product curve. TPP. which is 10.PRODUCTION AND COSTS 49 Fig. is obtained through dividing TPP by L in Table 3.3 are given respectively in figs.20 9. The MPP schedule corresponding to the TPP schedule in Table 3. just as marginal utility is obtained from total utility.3.2 shows the TPP curve for the TPP schedule given in Table 3.3 and 3. given in column (3) of Table 3.4. is equal to the difference between TPP at L = 2.2.3. Table 3. which is 22. 3.75 10. It is not true that the concepts of TPP. Note the following : 1.
we see that MPP is positive in this range. in Table 3. 3. In Table 3. In stage I. then it diminishes and finally it becomes negative.g. the TPP at L = 3 is equal to 33. TPP decreases from L = 8 onwards. TPP increases up to L = 6. Then we can get TPP by adding MPPs (as TPP is the sum of MPPs). the MPPs at L = 1.3.3. and.2. Law of Variable Proportions and Law of Diminishing Returns As we will see later in this chapter and in the next. but one at a time. the most important schedule (curve) from our viewpoint is the marginal physical product schedule (curve). TPP must be increasing and if MPP is negative. Similarly. its MPP increases.2. land or Fig. It is applicable to all inputs. 3. 3. if the APPs are known. Since MPPs are additions to the TPP. In Table 3. when the level of an input’s employment is sufficiently low. 2 and 3 add up to 33. 2. in general. Then MPPs are obtained by applying its definition. we get TPP by multiplying APP with the level of employment. 4.3 variable input increases. we can readily obtain APP by applying its definition. TPP must be decreasing as the level of the . labour) and not to others (e. in Table 3. TPP is the sum of MPPs ( just as total utility is the sum of marginal utilities). given any one of these. in stage Fig. it decreases but remains positive.g. We notice from fig. This pattern of MPP is called the Law of Variable Proportions. 3.3 equipment). from Table 3. MPP is negative in this range. In Table 3. this law outlines three stages of production.2. we can derive the other two. This relationship is verified from TPP and MPP schedules.3 that the MPP initially increases with an increase in the employment of the input in question. For example. In stage II. finally. Although we have derived MPP and APP from TPP above.3 The Marginal Physical Product Curve Corresponding to Table 3. Suppose MPPs are given to us.50 INTRODUCTORY MICROECONOMICS one particular input (e. The MPPs being additions to the TPP also implies that if MPP is positive.3.4 The Average Physical Product Curve Corresponding to Table 3. Put differently. Once we get TPP.
3 etc. TPP increases with the employment of the variable input as MPP in this range is positive. factor proportions become increasingly unsuitable for production. Note that in stages I and II. it decreases since MPP is negative. We observe that the MPP increases between 0 to A. stage III sets in at L = 8.5 Three Stages of Production and Diminishing Returns maximising firm will not operate in stage I either. but. The reason behind the law of variable proportions or the law of diminishing returns is fundamentally the same. As the employment of a particular input gradually increases while all other inputs are kept unchanged. But in stage III. 3. in which the marginal returns to an . Diminishing returns holds in stages II and III. it becomes negative. its marginal physical product decreases with further employment of it. 3. 2. the variable factor can work with other given inputs only less efficiently. stage II is operative between L = 3 and L = 7.5 illustrates these laws more clearly. a firm will have to incur higher costs on one hand (as it is hiring more of the input). the employment of other inputs remaining the same. after a certain level. after a certain level. and. not just in integer units like 1. MPP and APP curves will look smooth. From the point B onwards. by entering stage III. The MPP diminishes but remains positive between A to B. Fig. and. That leaves out only stage II. which marks stage II. at the same time. Closely associated with this law is another important law. it goes by the name of the law of diminishing returns. as more of a particular input is used in production. called the law of diminishing marginal product or the law of diminishing marginal returns (which is similar to the law of diminishing marginal utility). wherein the MPP is negative. The significance of these stages of production is that a profit-maximising firm will never operate in stage III. in the output market. stage I holds till L = 2. that is. 3. Suppose that the input can be measured continuously like points on a line. it is the stage III. This region marks stage I. the factor proportions become initially more suitable for production. but we will learn in Chapter 7 that a profit- Fig. since output is falling.PRODUCTION AND COSTS 51 III. It is not obvious at this point. it will get less revenues. It is because. This implies that profits will be less. More briefly. In our example. A smooth MPP curve is drawn in fig. This says that. Then the resulting TPP.5.
2 COSTS We now move on to discuss some cost concepts. a firm faces two types of costs: fixed costs and variable costs.1. 3. Fixed costs are those that do not vary with the level of output. (b) and (c) respectively illustrate increasing returns to scale. Similarly. Increasing (respectively decreasing) returns to scale hold when output increases more (respectively less) than proportionately. the combination C has double the amount of each input. 1 unit of labour and 2 units of land produce 5 units of output. The effect of this change on output is captured by the notion of returns to scale. In other words. this implies that the APP curve is inverse U-shaped also.g. Of course. 3. Likewise. From the viewpoint of the operation of the firm. the output is going to increase. Constant returns to scale hold when output increases exactly by the proportion in which inputs are increased.2. finally from F onwards there are decreasing returns to scale. This point will be clearer as we go along. cost concepts are very much related to concepts associated with the production function. Finally. note that the law of diminishing returns implies that the MPP curve is inverse U-shaped. “diminishing” or “constant” mean that the output decreases or remains 5 constant: the output always increases when all inputs are increased. Why? In combination B. this is the most relevant stage. But by how much? Will it increase (a) by more than 20%. You should not make the mistake that the ter ms “decreasing”. As fig. but output (equal to 11) is more than double of the output at combination B. Compared to B.52 INTRODUCTORY MICROECONOMICS input is positive but diminishing.1 contains stages showing all three types of returns to scale. (These are also called overhead This holds as long as the MPP of each factor is positive. and. suppose all inputs are increased by a given proportion. In turn.e.3 Returns to Scale Suppose that. the firm is not operating in stage III. inputs increase by 50% but output increases by more than 50% (as 18 is more than 50% higher than 11). . in the range from D to F. i. instead of increasing one input at a time. there are constant returns. For example. from C to D.1 Short Run Fixed and Variable Costs At a given point of time. (b) by less than 20% or (c) exactly by 20%? The possibilities (a).. by 20%). decreasing or diminishing returns to scale and constant returns to scale. you increase the employment of all inputs by the same proportion (e. 3. you can calculate that. 3.1 suggests. from B to D there are increasing returns to scale.5 The production function outlined in Table 3.
Average total cost is sometimes loosely called average cost only. AFC = TFC/Output and AVC = TVC/ Output. total fixed costs + total variable costs. There is a time element in interpreting these costs as fixed. Instead of being termed simply fixed and variable cost. in a long run horizon.. does. That is. the AVCs and the ATCs corresponding to . we obtain the Average Total Cost (ATC). not in the long run. Besides fixed cost. e. Table 3. Variable costs increase with output.g. TC = TFC. even if these costs are fixed at any given point of time or within a short time period. you operate a garment factory. we return to the short run situation. Notice that. at the zero level of output. You pay a fixed rent for the factory building. The columns (2) and (3) against column (1) are respectively total fixed cost and total variable cost schedules. we respectively get the Average Fixed Cost (AFC) and the Average Variable Cost (AVC).) For example. these curves are upward sloping. Hence the rent and insurance costs etc. But TVC. given in the last column of Table 3. since TVC and TC increase with the output.PRODUCTION AND COSTS 53 costs.6 depicts these. Average Costs If we divide total fixed cost and total variable cost by output. In other words. Similarly. Total cost (TC) is then. If you want to produce more garments. the total cost curve is the vertical summation of the total fixed and total variable cost curves. that are fixed in the short run can vary in the long run. by definition. Hence. The TFC curve is horizontal because fixed costs do not change with the output. Having noted this difference. you can think of renting more or less space. i. That is. there are variable costs − those that change with the level of output. by definition. fixed costs are present only in the short run. fixed insurance payments for your machinery against fire etc. you have to buy more cotton and other raw materials. given in column (2). these are formally called Total Fixed Cost (TFC) and Total Variable Cost (TVC).. They refer only to different periods of planning horizon by producers in an industry. Notice that TFC. The AFCs. they can vary from one industry to another. hire more workers and so on. because TVC is zero when output is zero. Note that these notions of short run and long run do not refer to any particular calendar time. together with the total cost curve that graphs the TC schedule.e. given in column (3). These are independent of how many garments per month you produce. labour costs and costs of raw materials. Figure 3. Graphs of these schedules are the total fixed cost curve and the total variable cost curve respectively. do not change with output. Note that. By definition.4. having more or less number of machinery depending on your business outlook for the future. ATC = AFC + AVC. ATC = TC/Output.4 presents a numerical example. However. by dividing total cost by output.
The MC of this output level is Rs. In the example given in Table 3. Marginal Costs There is another important cost concept. they are U-shaped. and fig.e.4 Table 3.) 10 18 23 26 30 36 45 57 73 93 Total Fixed Costs (Rs. suppose that the current level of output is 7. The reason behind this shape will be discussed later.54 INTRODUCTORY MICROECONOMICS Table 3. 3.4. 12. the marginal cost (MC). It is because the 7th unit of output costs Rs. Thus. it is the (additional) cost of producing an extra unit.6 TFC.4 Output 0 1 2 3 4 5 6 7 8 9 Total Fixed Costs and Total Variable Costs Total Variable Costs (Rs. 57 – Rs. 45 = Rs. this is defined as the increase in total cost when one extra unit is produced. The AFC curve continuously decreases as output increases.6. because the numerator of the ratio TFC/Output is constant while the denominator increases.7 graphs them.4 are given in Table 3. The AVC and .4 is given in Table 3.) 0 8 13 16 20 26 35 47 63 83 Total Costs (Rs. Fig.) 10 10 10 10 10 10 10 10 10 10 ATC curves slope downwards initially and then upwards.5. Similar to marginal utility or marginal product. i. 12. TVC and TC Curves corresponding to Table 3. 3. The MC schedule corresponding to Table 3.
MC can be equivalently defined as the increase in the total variable cost when one extra unit is produced. since total costs and total variable costs differ only by a constant term (equal to the total fixed cost).33 5 5.125 10.5 Note that.25 1.50 7. 3.) AVC (Rs.) 10 5 3. Fig. For example.11 8 6. For example. That is. 3.20 5.50 8.8 graphs the MC schedule given in Table 3. This result will be used in Chapter 4. and.5 Output 0 1 2 3 4 5 6 7 8 9 AFC.7 AFC.66 1. the TVC is equal to the area 0ABq0 . 8) and that of producing two units (= Rs. It is the marginal cost curve.875 9. at output q0 .) ATC (Rs.9.50 5. 13.PRODUCTION AND COSTS 55 Table 3. 5). this is the sum of the MC of producing one unit (= Rs. Recall that the TVC is sum of the marginal costs.33 Fig.22 18 11. a smooth (hypothetical) marginal cost curve is drawn in fig.4) AFC (Rs. 3. the TVC of producing 2 units is Rs. AVC and ATC Curves Corresponding to Table 3.20 7.66 7.50 8.71 7.50 2 1.14 9. Moreover.33 2. the TVC is equal to the area under the marginal cost curve. Assuming that the output is per fectly divisible.6.84 6. .43 1. This implies a property associated with a smooth marginal cost. TVC is equal to the sum of MCs (just as total utility is the sum of marginal utilities). AVC and ATC Schedules (Based on Table 3.
25 20 15 10 5 0 0 1 2 3 4 5 6 7 8 Marginal Costs (based on Table 3. the rate of increase in the variable cost − which is same as the marginal cost − will be less and less as output increases. an increase in any given input leads first to an increase in its marginal physical product. This implies that. i. interpret the other inputs. the total payment to which is the total fixed cost. which are kept unchanged.9. 3.e. initially. Let us suppose that this particular input is the only variable input. initially. it will be more and more.8 The MC Curve corresponding to Table 3.56 INTRODUCTORY MICROECONOMICS As you see from fig. leads to a decrease in its marginal physical product.) 8 5 3 4 6 9 12 16 20 unchanged. this law says that. so that the total payment to it is equal to the total variable cost. it is U-shaped. The reason behind the Ushape of the MC curve is the law of diminishing returns.9 A Smooth Marginal Cost MC Output 9 10 Fig. and. and then.8 or fig.6 Output 0 1 2 3 4 5 6 7 8 9 Costs in Rs . 3. then. after a certain point. As you recall. as the fixed factors.4) Marginal Cost (Rs. as more and more output is produced. the MC curve is initially decreasing in output and then it is increasing. it will be more and more when output . and. 3. the rate of increase in the requirement of the variable input will be less and less. as other inputs are kept Table 3. Similarly.6 Let us now turn around the statement of the law of diminishing returns and say equivalently that. Fig. after certain point. 3.
e. it can be understood through the following example. There is indeed another relationship that holds between AVC. Now.PRODUCTION AND COSTS 57 increases further. This is contained in Richard Manning and Kenneth Henry. if the average had fallen from 49. 3 wickets are down. This simple deduction means the following. Chapter 7. Suppose that you are interested in calculating the average score of batsmen out as wickets continue to fall. The Logic of Markets. which depicts smooth AVC. Then it must be true that. because otherwise the average wouldn’t have increased.” Why. ATC and MC curves. Has then the fourth batsman. hence MC > AVC.10. This explains the Ushape of the MC curve. . The Dunmore Press Limited. ATC and MC curves. scored more or less than 49? The answer is “more. The runs scored by those already out are say 40. not economic.6 Once we know that the MC curve is U-shaped. Similarly. when 3 are already out). You calculate the average again and find that it has increased from 49 runs. it follows that the AVC and the ATC curves are U-shaped also. Observe that the MC curve cuts the AVC and ATC curves at their minimum points.10. the MC curve is a mirror reflection of the MPP curve. The AVC curve is decreasing in the range of output from 0 to q0. (b) at any output greater than q 0 . 6 7 Fig. Likewise.10 AVC. MC < AVC. Hence the above logic applies to the relationship Indeed. The game goes on and the fourth wicket falls. say. 3. statements (a) and (b) together imply that the MC curve must cut the AVC curve at the AVC’s minimum point. Consider fig. 3. (a) at any output level in this range. 105 and 2. Now go back to fig. 3. the “marginal” should be above (respectively below) the average. Think of the runs scored by the fourth batsman out as “marginal” (i. The average is (40 + 105 + 2)/3 = 49. 1983. ATC and MC Curves “additional” runs scored by the next “unit” or batsman. MC is the addition to both the TVC and the TC. who got out. The reason behind this is mathematical.7 Consider the game of cricket. We are then saying that if the average increases (respectively decreases). the fourth batsman must have scored less than 49. AVC is increasing in output. New Zealand. By definition. Begin to calculate this after. and.
the LAC curve is flatter than short-run average variable cost curves. This means that. which determines the U-shape of these curves. inputs need to be increased only by less than proportionately (say by 7%). In what follows. . increasing returns to scale mean that if output is increased at a given rate (say 10%). 3. The former cuts the latter at its minimum point too. in general. it is the pattern of the returns to scale. Instead. the LAC and LMC curves.” Similarly. the average cost is constant − independent of output. Finally. there are no TFC or AFC curves in the long run.58 INTRODUCTORY MICROECONOMICS between MC curve and ATC curve also. 3. This implies that the average cost must fall as output expands. There is no distinction between total costs and total variable costs. Similarly. in the long run. and. all inputs are variable. where L stands for long run.11. we simply use the term “total costs. the LMC curve cuts the LAC at its minimum point. It shows a U-shaped LAC curve. Now look at fig. because costs that are fixed in the short run can be changed if the planning horizon of the producer is long enough. we will abbreviate it to LMC. decreasing returns to scale imply that the average cost must rise with output. Like the short run average and marginal cost curves. The concept of marginal cost remains exactly the same however. we discuss the shapes of the LAC and LMC curves. since all inputs are variable. 8 8 In particular. 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.11 The Long-Run Average and Marginal Cost Curves The short-run and long-run average or marginal cost curves are not unrelated however. As you will learn in a higher course in microeconomics. denoted by LAC. the reason behind the U-shape is not the law of diminishing returns. 3. if returns to scale are constant. as output is gradually increased Fig.2. are U-shaped.2 Long Run Recall that. Accordingly. However. there is no distinction between average total costs and average variable costs and we will use the term “long-run average cost”. the reasons behind their shapes and the relationship between them.
which lead to decreasing returns to scale. the LAC will have a flat portion in the middle. CRS and DRS respectively. the firm may have only one room. Storing merchandise and taking them out generate traffic. 3. Now. However. In between IRS and DRS. there are increasing returns to scale (in the output range 0 to q0) such that LAC falls. The same applies to other kinds of workers and to machinery and land. one of them can be used as storage only and as a result the productivity of employees will improve. To cite an example in case of for mer. instead. This is different in nature from the short run. More generally. a firm experiences constant returns to scale. a garment factory buys 100 tons of yarn at a certain price. for instance. Crowding and congestion occur typically.11. the firm acquires an additional room. this is the level at which production is most efficient. which is used as a storage as well as office space for its employees. as the scale of operation increases. suppose that a fir m has only o ne manag er. then constant returns and finally decreasing returns to scale occur as output increases. If. the long run average cost is minimised where constant returns to scale prevail. wh o s e speciality is in marketing but who is looking into both marketing and manufacturing. increasing. In some sense. A couple of remarks are in order: First. given that initially increasing returns. which would adversely affect the productivity of other employees. a firm would be able to reap the advantages of (a) division of labour and (b) volume discounts. followed by CRS and DRS? Starting from a relatively smallscale operation (output). The concepts developed in this chapter will be used very much in the following chapters. then each manager can specialise in their expertise and be more efficient. In fig. Now the question is why do IRS occur first. it 9 plans to buy 200 tons of yarn it can negotiate a better price. at a small scale of operation. then there are constant returns to scale (at q0). such that LAC increases with output.PRODUCTION AND COSTS 59 starting from a small level. Second. 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. meaning allocation of tasks according to the specialisation of workers. . 3. difficulties in managing an enterprise crop up. In this case. This is called division of labour. It is shown at point q0 in fig. such as at point q0. and finally decreasing returns to scale prevail at output levels higher than q0. as the firm increases its production and hires another manager who expertise is in manufacturing. 9 In case of volume discounts. constant and decreasing returns to scale are written in short forms as IRS.11. as the output level goes beyond a certain limit. If. the U-shape of the LAC curve implies the U-shape of the LMC curve. For instance. CRS may prevail over a range of output. instead.
. The MC curve cuts the AVC curve and the ATC curve at their minimum points. In the long run. there are only variable costs. A profit-maximising firm will never employ an input at such a level that its MPP is negative. the MPP increases with input employment. then it diminishes but remains positive and finally it becomes negative. AVC and ATC curves are generally U-shaped. The U-shape of the LAC curve implies the U-shape of the LMC curve. The sum of MCs equals the TVC. The long run marginal cost (LMC) curve and the long run average cost (LAC) curve are generally U-shaped.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 LMC curve cuts the LAC curve at the latter’s minimum point. In the short run. the sources of increasing returns to scale lie in the division of labour and volume discounts. The area under the MC curve is equal to the TVC. the inverse U-shape of the MPP curve implies a similar shape of the APP curve. the shape of the MC curve implies the similar shape of the AVC and ATC curves. The law of diminishing returns explains why the MPP curve is inverse Ushaped. There are generally three stages of production. In the initial stage. followed by constant returns to scale and then by decreasing returns to scale. there are fixed costs and variable costs. The AFC curve is downward sloping. In turn. The U-shape of the LAC curve follows from a firm experiencing increasing returns to scale initially. The MC. In turn. In the long run. The law of diminishing returns explains why the MC curve is U-shaped. The MPP and APP curves are generally inverse U-shaped.
4 3. (b) Minimum telephone bill.19 3.10 3. (f) Payment for transportation of goods.24 . (h) Daily wages.9 3.5 3.6 3. Classify the following into fixed cost and variable cost. (a) Rent for a shed.7 3.1 3.8 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.15 3.16 3.3 3.22 3. (d) Wages to permanent staff.PRODUCTION AND COSTS 61 EXERCISES Section I 3. (c) Cost of raw materials.12 3.23 3.14 What is a production function? List any three inputs used in production.11 3.13 3. 3.20 3. Give the meaning of decreasing returns to scale. Give the meaning of constant returns to scale. 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.17 3.21 3.18 3. (e) Interest on capital. (g) Telephone charges beyond the minimum.2 3.
It is also known that the TPP at zero level of employment is zero.27 TPP 0 5 12 20 28 35 40 42 The following table gives the MPP of a factor.62 INTRODUCTORY MICROECONOMICS Section II 3. Level of Factor Employment 0 1 2 3 4 5 6 7 3.25 3. Determine its TPP and MPP schedules. Determine its TPP and APP schedules. It is also known that the TPP at zero level of employment is zero. . Level of Factor Employment 1 2 3 4 5 6 MPP 20 22 18 16 14 6 3.28 The following table gives the APP of a factor.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.
Why is the MC curve in the short run U-shaped? A firm is producing 20 units. Do ATC and AVC curves intersect? Give reasons.31 3. 40 and Rs.35 3.32 3.PRODUCTION AND COSTS 63 Level of Factor Employment 1 2 3 4 5 3. In other words. 37.30 3.29 APP 50 48 45 42 39 3. 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. explain the relationship between TC.37 A firm’s total cost schedule is given in the following table. 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. TFC and TVC.34 3. Section III 3.36 6 35 Explain the law of diminishing marginal returns.33 3.) 40 120 170 180 210 260 340 440 550 . At this level of output. With the help of a suitable diagram. the ATC and AVC are respectively equal to Rs.
Output 1 2 3 4 5 6 7 8 TC 90 105 115 120 135 160 200 260 TVC TFC AVC AFC ATC MC 3.500 2.38 What is the total fixed cost of this firm? Derive the AFC.000.500 .200 1. AVC.000 2.) 2. Complete the following table if the AFC at 1 unit of production is Rs.64 INTRODUCTORY MICROECONOMICS (a) (b) 3. ATC and MC schedules. Output (in units) 1 2 3 4 5 6 7 Marginal Cost (in Rs. TC and ATC from the following table.000 1. 2. Compute the TVC. AVC.500 1.39 A firm’s fixed cost is Rs. 60.700 3.
Show that the production function given in Table A satisfies increasing returns to scale and that in Table B satisfies decreasing returns to scale.) 10 20 30 40 50 60 70 (a) (b) 3. AVC and MC with a suitable illustration. 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 .41 3. There are two factors: unskilled labour and skilled labour.PRODUCTION AND COSTS 65 3. Will the AVC curve be U-shaped? Discuss why or why not. 100.42 Is the MC curve U-shaped? Derive the AVC schedule.40 Suppose that a firm’s total fixed cost is Rs. Tables A and B below outline two production technologies or production functions. Explain the relationship between ATC. and the marginal cost schedule of a firm is the following. Output (in units) 1 2 3 4 5 6 7 Marginal Cost (in Rs.
66 INTRODUCTORY MICROECONOMICS Table B Unskilled Labour (in hours) 8 10 12 14 3.43 Skilled Labour (in hours) 4 5 6 7 Output (in units) 6 7 8 9 “Increasing and decreasing returns to scale respectively imply downward and upward sloping portion of the long run average cost curve.” Defend or refute. .
In the last chapter.7 Price Elasticity of Supply .e. we first analyse how total revenues. together with the cost concepts. But we did not learn about their choice behaviour i. there is • • • 4. PRODUCERS EQUILIBRIUM AND THE SUPPLY CURVE Besides the demand forces. the supply curve shows different quantities produced and sold at different prices.6 Time Horizon 4. We also discussed how total costs change with output. In this chapter we develop the revenue concepts. defined as price × output. This sets the stage for analysing profit maximisation or what is called producer’s equilibrium. PRODUCER'S EQUILIBRIUM AND THE SUPPLY CURVE 67 CHAPTER 4 REVENUES. the supply forces constitute the other crucial component of market mechanism.4 Determinants of Supply Curves Market Supply Curve • 4.REVENUES. and. It is an equilibrium notion in the sense that if the firm selects the level of output at which profit is maximised. which are relevant for producers. change with output. This. in turn. Comparable to the demand curve.3 Change in Quantity Supplied Versus Change in Supply 4. we saw that profits are equal to the difference between total revenues and total costs.5 • • • 4. we study profit maximisation.1 Total Revenues 4. it would like to “stay” or “rest” at that level of output. In this chapter. It is the producers who supply goods and services to the market.2 Producer's Equilibrium: The Basis of the Supply Curve 4. In the last chapter we studied concepts associated with production and cost. forms the basis of what is called the supply curve. which level of output they should produce so as to maximise their profits.
which is of central importance in economic analysis.1 Perfect Competition The following six characteristics define perfect competition or a perfectly competitive market.e. The chosen examples are different from. identical) product or service. Similarly. for most practical purposes. namely. 2 You can of course argue that there may be some differences between wheat produced in Punjab and wheat produced in Australia. the market for TVs. How it may change will be studied in Chapter 5.2 An example may help to better understand the price taking behaviour. there are typically many producers of these items. a standard haircut may differ slightly from one barber to another.68 INTRODUCTORY MICROECONOMICS no incentive for it to increase or decrease output from that level. (C) There is free entry and exit. naturally homogeneous. each firm is a price taker in perfect competition. 4. There are black and white TVs as well as colour TVs. no one will buy from the former. say. which are differentiated. That is because if one producer happens to charge a price higher than some other. Even in the category of colour TVs. which are very close to perfectly competitive markets.. But. But the markets for goods and services like wheat. Why would anyone pay more for exactly the same item? Hence. But. In this chapter. (E) Uniform price. a standard hair 1 cut or a leather football can be thought of as examples of industries.1 The implication of the product being homogeneous or identical is that all firms have to charge the same price for the product. i. (A) There are a large number of buyers and sellers (producers). the effect of a change in output on the total revenue of a firm depends on the market structure. Other types of market structure will be studied in Chapter 6. . (F) No transport and selling costs. Moreover. Each of these is a standardised item.1 TOTAL REVENUES Unlike costs. which refers to the number of firms operating in an industry. we will consider only one kind of market structure.1. there are 19" TVs and 29" TVs. perfect competition. the differences are negligible. If you operate a halwai (sweetmeat) shop in a big town in which there are many such halwai shops. Because. (B) Firms sell a very homogeneous (i. TVs differ not just in quality but also in style and design. 4. which exactly fit the definition of perfect competition. That is. all producers who operate in the market must charge the same price. (D) Perfect knowledge. again. the nature of competition between them and the nature of the product. It is hard to find markets. 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. it is essentially the same everywhere.e. This does not mean that the market price itself cannot change. it is relatively easy to enter or get out of these businesses. Think of a product like jalebi (a sweet).
it is quite simple to relate total revenue (TR) to output. it is able to sell to the consumers any amount it wishes at the same price. This is called the price line. 70/kg 3 The feature (C) of perfect competition. At zero output. Suppose that the firm is producing the amount q0.2. That is. 70 too. if you sell five kilograms of jalebi.REVENUES. you will not charge more than Rs. Obviously.3 For example.1(b) now. it is Table 4.) 0 70 140 210 280 350 420 490 560 Rs. 70 × 5 = Rs. the market price of jalebi per kg is Rs. you will charge Rs.) There is a relationship between the price line and the total revenue. all customers). If you sell six. because being small compared to the market. Thus you will be a price taker. does not have any direct bearing on how TR changes with respect to output. the total revenue is equal to the area under the price line. (The price elasticity of this demand curve is infinite.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. Hence the TR curve must pass through the origin. free entry and exit. 420 and so on.3 Total Revenue Curve and Price Line If we graph the total revenue schedule. *Market price jalebi = Rs. This is seen in fig. we obtain the total revenue curve. which is the area under the price line.1 Total Revenue Schedule Output In Kg. measuring output along the x-axis and total revenue along the y-axis. Then. It is also called the “demand curve facing a competitive firm” in the sense that. Turn to fig. There is also no reason for you to sell at any price less. you can “sell” as many jalebi as you like at the going price in the market. Its implication will be studied in Chapter 6. 350. namely. 0 1 2 3 4 5 6 7 8 TR (Rs. in which AB is a hypothetical price line. 70. TR is obviously zero. from a firm’s perspective. This is depicted in fig. . PRODUCER'S EQUILIBRIUM AND THE SUPPLY CURVE 69 and. Moreover. 70 (and lose a lot of. 4. TR = price × quantity = OA × Oq0 = OADqo. Since the market price is given or “exogenous” to the firm. possibly.1(a). it is a straight line. 4. we obtain a horizontal line. not total revenues. 4. 4. This is because the market price is independent of how much quantity is sold by one firm. the TR is Rs. Table 4.1. 4.1 reports the total revenue schedule for this example.1. The y-axis measures price.
In order to do so.4 Average Revenue and Marginal Revenue These are two more “revenue” concepts. 4.5 However.4 Since a competitive firm is a price taker. 4. if it sells one extra unit. we use a graphical method to answer this question. the extra r evenue generated will be equal to whatever the price is. we need two results from our study of costs and revenues: Fig. Note that. AR is always equal to price. it is the revenue obtained from one extra or last unit sold. It is equal to TR/output.1 4.1.2 Price Line and Total Revenues 4 5 This is similar to the concept of marginal utility or marginal cost. Marginal revenue is defined as the increase in total revenue when one extra unit is sold. for a competitive firm. This is not true for a firm. MR = price. . i. 4.e. which is not perfectly competitive. Here they are introduced for the sake of completeness. since TR = price × output. But they will be in Chapter 6.2 PRODUCER’S EQUILIBRIUM: THE BASIS OF THE SUPPLY CURVE We are now ready to study producer’s equilibrium. Average Revenue (AR) is defined as revenue per unit of output.70 INTRODUCTORY MICROECONOMICS (a) (b) Fig.1 Total Revenue Curve and the Price Line corresponding to Table 4. Thus. the terms of AR and MR will not be used much in this chapter. 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..
the gross profit is less.e.REVENUES. at any level of output either less or greater than q0. Fig.2. . is that marginal cost be increasing with output. where P = MC. Hence. a competitive firm’s profit is maximised at the point where the price line intersects the MC curve. At which level of output is the firm’s profit maximised? The answer is q0. and TVC = the area under the MC curve = 0DAq0 . However. 4.1 The Profit-Maximising Condition Turn now to fig. 4. Thus gross profit = 0P0Aq0 – 0DAq0 = DP0A. in general. 6 say q'. suppose that. thus gross profit = 0P 0 A"q" – 0DCq" = DP0A – ACA". By similar calculation. this is equal to profit plus TFC. hence profits. say q". The total revenue is equal to 0P0A"q" and the total variable cost is equal to 0DCq". The total revenue is equal to the area under the price line. 4. 2. with P denoting the market price. Look at next. at the market price P0. Observe the similarity of this condition with the condition for consumer’s equilibrium in Chapter 2. To see this.2.3 Profit Maximisation 4. 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. where (A) P = MC. P = MC. This is the profit maximising condition or the condition for producer’s equilibrium. since TFC is constant. We have TR = the area under the price line = 0P0Aq0. where the price line P0 intersects the MC curve. profit is maximised where gross profit is maximised and vice versa. a level of output greater than q0.2 Rationale Behind the Condition. are maximised at q0. we are saying that. In other words. PRODUCER'S EQUILIBRIUM AND THE SUPPLY CURVE 71 1.3.6 Why is profit maximised where the price line intersects the MC curve? Define gross profit equal to TR – TVC. Its marginal cost curve is denoted by MC. Now consider any output less than q0. Notice that this is less than DP0A. the gross profit = DP0A'B. We now argue that..” In a parallel way. starting from the level of output at which P =MC. Suppose that a competitive firm faces the market price P0. P0A" is the price line. and. that is. the gross profit is maximised at the output q0. i. The total variable cost is equal to the area under the marginal cost curve. This is also less than DP0A. the key reason behind the producer’s equilibrium condition. which stated that marginal utility be equal to price. By definition. This proves that gross profits.
and thus profit is a higher. the marginal revenue. the profit-maximising b a output is q1 not q1 . Hence. The above discussion implies that. It is because. Hence. this is a very general condition of profit-maximisation − something that holds irrespective of the market structure. Given that MC is increasing in output. the extra revenue generated is P1 and the extra cost incurred is equal to MC. Indeed. q1 and q1 . Fig.2. 4. 4. In this case the revenues sacrificed (equal to P) are greater than savings in costs (equal to MC).3 A More General ProfitMaximising Condition Recall the definition of MR. suppose that the firm decides to produce one unit less than where P = MC. In summary then. extra revenues will be less than the extra costs. but. Therefore. b a unlike at q 1 . as long as MC is increasing in output. You can similarly argue that profit is less also if output is reduced by one unit from q1 . at q 1 . the more a producer wants to supply. If it increases output by one unit. Thus.4 Law of Supply and the Supply Curve The law of supply states that.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. it cannot be the profit-maximising level of output.4. 4. marginal revenue is equal to marginal cost. if at any given market price there is a level of output at which P = MC holds but MC is decreasing. But P and MC are respectively equal to extra revenues earned and extra costs incurred. But since MC is decreasing. profit is maximised where P = MC. At price P1. Such a possibility is shown in fig. an increase in the price of a product leads to an increase in the quantity supplied of it. other things remaining unchanged. That is. implying that the profits will be less. a profit is not maximised at q1 . Similarly. MC decreases. higher the price. and that P = MR for a competitive firm. we however return to P = MC as our profit-maximising condition for a competitive firm.4 Profit Maximising Outputs at Different Prices 7 a Suppose the firm is producing at q1 . . Having noted this. Thus we can write (A) as MR = MC. increasing or decreasing output from where P = MC results in less profits. the price line cuts the MC a b curve at two points. P1 > MC. 4.2. P will be now less than MC. profits will also be less.72 INTRODUCTORY MICROECONOMICS the firm decides to produce one unit more. Hence.
. the factors that shift the marginal cost curve are the determinants of supply or the supply curve. there are taxes that are based on the total production 8 Strictly speaking. PRODUCER'S EQUILIBRIUM AND THE SUPPLY CURVE 73 “Other things” refer to other determinants of supply.2 Since the supply curve is a part of the marginal cost curve. We can think of the output as the amount supplied to the market (assuming implicitly that the firm does not store anything beyond one period).5 The Supply Curve for the Supply Schedule in Table 4. Table 4. This law. there are two such factors. A change in quantity supplied refers to a movement along a given supply curve because of a price change. and so on. the graph of a supply schedule gives the supply curve. technological changes and changes in factor or input prices. at price P2. stated in a tabular form. Generally. which will be discussed later. Hence it follows that the rising portion of the MC curve is the supply curve itself ! 8 4. on many industrial goods. the b firm produces the amount q1 . whereas a change in supply means a shift of the supply curve due to a change in “other factors. The reason for this will be covered in a higher course in micro economics.) 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. and.REVENUES. Figure 4.2 A Supply Schedule Price (Rs.” It is now the time to discuss these factors. 4. We see that. it produces q2.4 DETERMINANTS SUPPLY CURVE OF THE Fig. What is the basis of the law of supply or the supply curve? Refer back to fig.4. 4. 4. the supply curve is only a portion of the rising part of the MC curve.2 lists a supply schedule. at price P1. in India particularly.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.5 graphs the corresponding supply curve. Besides. gives rise to the supply schedule. Hence all Table 4.
9 4.1 Technological Changes printed pages are much less today than they were prior to 1980s. development of new products. in both cases. There is another kind of technological progress that we do not consider here. namely. we have the result that a technological progress shifts the supply curve to the right. As we can see. that is.74 INTRODUCTORY MICROECONOMICS cost of output of a firm. Once manuscripts of books were prepared by authors in long hand. In the real world. The whole plate had to be changed if changes were to be made in the pictures or diagrams. As we will see. wages to workers etc. a change in the rate of excise duty will also shift the supply curve. The metal plate and the frame were mechanically inked and pressed on to paper to produce a page of the book.3 illustrates this. Changes are nearly costless to include. prices of essential goods typically rise.4. war. The supply curve is also influenced sometimes by price speculations. namely.4.10 Now a days. the new MC curve lies below or to the right of the old one. changes in the prices of related goods. we consider these determinants of supply. This is an example of cost-saving technological change. But we ignore them here. 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. In old days. bringing out a book in print was a fairly complex process.11 Such a technological advance lowers marginal cost at any given level of output. In what follows.6. expecting to sell later at very high prices. with computers. The pictures and diagrams were etched on metal plates. Some private producers take advantage of this situation by “hoarding”.12 Notice that each entry in Column (3) is smaller than the corresponding entry in Column (2). all tasks except for printing are done in a computer. withholding supply of their product to the market. For simplicity. meaning that the marginal cost has decreased for any given level of output. the alphabets in the manuscripts used to be set in a frame and the frame would be mounted on a letter-press machine. the marginal cost always increases with output. there are many such examples. In times of disasters like earthquake. Consider for instance the printing business. 4. word processing.2 Input Price Changes Changes in raw material prices. We ignore these factors in this chapter. Column (2) lists an old marginal cost schedule. famine and cyclones. Using printers to print is also an easy and fairly inexpensive job. Column (3) lists the new one after the technological change. . 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. The two marginal cost schedules are plotted in fig. These are called excise taxes or excise duties. Since the MC curve is essentially the supply curve. which can also shift the marginal cost curve. spread sheet and presentation packages. can also affect the marginal cost curve and the supply curve. 4. There is still another factor that our simple profit-maximising analysis does not capture. Table 4.
3 Changes in the Excise Tax Rate In India.) 7 8 12 14 17 22 New MC (Rs. Fig. an increase (a decrease) in an input price shifts the supply curve to the left (right). The hourly market wage of barbers increases for some reason. Therefore. manufacture or Fig.4.7 Increase in Input Prices and the Shift of the Supply Curve 4.4 Change in the Prices of Related Products Many producers. 4. Thus. you will employ fewer barbers and service less number of haircuts. a change in the rate of this tax affects the overall marginal cost.REVENUES. The case .4.6 Technological Progress and Shift of the Supply Curve saloon. As a result. 4. 4. PRODUCER'S EQUILIBRIUM AND THE SUPPLY CURVE 75 Table 4. this would increase the marginal cost and hence shift the MC curve and the supply curve to the left. 4. This will increase the cost of the haircut service that you provide and shift your marginal cost curve up or to the left.) 3 4 7 9 13 17 of an increase in input prices is shown in fig. these are taxes levied on the total production cost of a firm. an increase (a decrease) in the excise tax shifts the supply curve to the left (right). In general then. Hence they add to the total variable cost.3 A Decrease in Marginal Costs due to Technological Change Output 0 1 2 3 4 5 Old MC (Rs.7. with their given amount of resources. producers of various industries in the manufacturing sector pay excise taxes. For any given level of output. employ 10 barbers and service 120 haircut jobs a day now. As said earlier. Suppose the rate of excise duty on a particular product 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. the latter also shifts when the number of firms changes. compared to growing wheat.5 MARKET SUPPLY CURVE This is parallel to the market demand curve. For example. The total quantity supplied to the market is then A1 + B1. he will grow less corn even when the price of corn. the technology of producing corn and input prices (e. Hence. If the market price of wheat increases.8 the curves SA. 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). where A2 and B2 are quantities supplied by producers (firms) A and B respectively. apart from any factor. the total quantity supplied is A2 + B2. It is derived as the horizontal summation of individual supply curves. Note that a market supply curve is derived on the assumption of a given number of firms (100. This will shift the supply curve of corn to the left. 4. B’s supply curve and the market supply curve. 4. the market supply curve is derived in an equivalent. SB and SA+B respectively denote A’s supply curve. like a technological change or a change in any input price.g. 200 or whatever it may be). 4. the price of corn seeds) remain the same. shown along the SA+B curve against this price. Here. Similarly at P2. In fig.8 Individual Supply Curves and the Market Supply Curve . that shifts the individual supply curve and thereby the market supply curve. geometric way (so that you get to know both ways).76 INTRODUCTORY MICROECONOMICS grow more than one item. which he can use to produce wheat or corn (or both). It is because growing corn is less profitable now. An increase (a decrease) in the number of firms shifts the market supply curve to the right (left). Assume that there are two firms in an industry. Consider a farmer who has a given amount of land. at price P1 the producer A supplies A1 units and the producer B supplies B1 units. A and B. Fig.
Fig. it is that short a period within which firms cannot adjust their output to any change in price. as drawn earlier. In the 1980s came Maruti. Within a very short period.9. which is owned jointly by the Indian government and Suzuki Motor Corporation of Japan. It is defined as (B) Price elasticity of supply = es As you know. you would want to produce more by hiring more workers. the supply curve of a firm or the whole industry is vertical. 1. The market price that has been prevailing for a long time is one rupee a piece. get new machinery etc. Your production level in a very short period of time is given. many foreign companies started to produce and sell such as Daewoo of South Korea (Cielo).7 PRICE ELASTICITY OF SUPPLY 4. As a result. Suppose that you manufacture chewing gum. Until the seventies.6 TIME HORIZON An element of time lies behind the supply curve being upward sloping. Such a short period 13 is called the market period in economics. entered into the production of small sized cars (Indica). especially since the 1990s. Hyundai of South Korea (Santro). because inputs can be changed. 3 or Rs. Many foreign firms that couldn’t earlier enter the Indian market in different sectors can and do so now. the price elasticity of supply quantifies the responsiveness of quantity supplied to changes in price. .9 Supply Curve in the Market Period 4. an Indian Company. irrespective of whether the price may have changed to Rs. in the passenger car market there were only two companies that were allowed to operate: Hindustan motors (with Ambassador) and Fiat (with Premier Padmini). In the 1990s. Rs. it takes time to hire people.50. Thus.7. As a rational producer. you cannot make these changes. 4. more equipment etc. The resulting supply curve will be a vertical line. In a longer run − i. This will mean that your supply curve is upward sloping. 2. 4. as shown in fig. which earlier produced only trucks and buses. we can also say that more (less) competition shifts the market supply curve to the right (left). Now suppose the price increases to two rupees a piece. By definition. Honda of Japan (Honda City) etc. Thus liberalisation brings forth more competition. more chemical engineers.1 Definition and the Percentage Method of Measurement Parallel to price elasticity of demand.13 4. However. At this price.REVENUES. PRODUCER'S EQUILIBRIUM AND THE SUPPLY CURVE 77 When there is an increase (a decrease) in the number of firms. we say that there is more (less) competition in the market. you were producing 1 lakh chewing gums per month. This is good news for you.e. India has been following a path of economic liberalisation. The Indian automobile market is a prime example of this. Even Telco. in the short run or long run − the supply curve will be upward sloping.
Just as in case of price elasticity of demand. In this example. 4. 8.000 pens a month.7. given that the supply curve is positively sloped. When they were selling at the price Rs. (a) the price elasticity of supply is independent of units. 10 and S1 = 8. you produced and sold 5. extended towards the x-axis. (P1 − P0 ) / P0 ∆P / P0 where ∆ denotes the change.78 INTRODUCTORY MICROECONOMICS % change in the quantity supplied % change in the price On a given supply curve. then the price elasticity of supply is. Refer to fig. P0 = Rs. if two supply curves intersect. If the price rises to P1 and quantity supplied increases to S1. zero.4. If the supply curve is vertical. Panel (a) illustrates one.10. Hence S0 = 5. 4. the flatter one has higher price elasticity at the point of intersection. (a) Fig. obviously.000 pens a month. It shows three straight line supply curves. Thus. and [(S1 − S 0 ) / S 0 ] × 100 = [(8000 − 5000)]/ 5000] × 100 = 60.000. P1 = Rs. let P0 and S 0 denote the original price and quantity. The reasons are exactly parallel what they were in case of price elasticity of demand. As a numerical example.10 (b) (c) Price Elasticity associated with Straight Line Supply Curves .000. suppose that you manufacture one type of ballpoint pens. the % changes in price and quantity supplied are respectively [(P1 – P0 )/P0] × 100 and [(S1 – S0 )/S0] × 100. 8. 4. the price elasticity of supply can be measured by a convenient geometric formula. 10 and you are producing and selling 8. the price elasticity is positive. [(P 1 P ) / P ] 100 0 0 [(10 8) / 8] 100 25. for very small price changes. eS 60 / 25 2. and (b). intersects the x-axis in its negative (S − S 0 ) / S 0 ∆S / S 0 = (C ) es = 1 .2 The Geometric Method Also similar to point elasticity of demand. in which the supply curve. Hence. Now its market price has increased to Rs. Otherwise.
how could it not reduce employment? This is. for example. it has a very short run perspective. A firm is doing it in order to save costs. the point of intersection is the origin. that is. Finally. you can say that the point B is same as the origin. P0 is the original price. at the time when a machine is replacing a person or many persons. computerisation or mechanisation may. Hence there is little reason to believe that computerisation will reduce employment in the long run. who with their own bare hands. On the other hand. 4. having two major flaws. that is.REVENUES. the supply curve intersects the x-axis in its positive range. Also. a narrow point of view. 4. 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. expansion of the small-scale 14 The proof of this is beyond our scope. As the total variable cost curve shifts down. and second. Of course. The negative effects of computerisation are present only in the short run. . Thus BC = 0C implying e s=1. But this is hardly the end of the story.10(b). any straight line supply curve passing through the origin. First. BC/0C. In fig. implies price elasticity of supply equal to one. On the other hand.10(c). any technical improvement that is labour-saving – is or must be bad for employment.1.) Thus. in fig. In all panels. it is less than one (as BC < 0C). Finally. This means that the supply curve will shift out and more will be produced in the new equilibrium. irrespective of how steep or flat it is. both skilled and unskilled. 14 (Ignore for the moment fig. By the same argument. 4. If you replace a person with a machine. From the whole economy’s perspective. it has a negative effect on employment. the production possibility curve (see Chapter 1) shifts out. computerisation by itself creates demand for new types of jobs. the price elasticity is greater than one (as BC > 0C). along the supply curve in panel (a). CLIP 4-1 Does computerisation reduce employment? This is a sensitive issue for a populous country like India. A traditional typist who is replaced by a computer can learn word processing and possibly land a more paying job. It turns out that the point elasticity is equal to the horizontal segment BC divided by the quantity supplied 0C. in panel (C). make beautiful handicrafts. however.(c) in which there is no point B. along the supply curve in panel (b). take away the job of artisans. it leads to a greater productivity of workers and higher wages. the straight line supply curve passes through the origin. The traditional thinking is that computerisation – or for that matter. 0C is the quantity supplied and A is the point on the supply curve. so does the marginal cost curve. Yes. PRODUCER'S EQUILIBRIUM AND THE SUPPLY CURVE 79 range at point B. Higher output would require more employment of workers. That is.
but other category of workers will now find jobs. attains producer’s equilibrium. 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. i. A perfectly competitive firm maximises profits. price is equal to marginal cost. when price is equal to the marginal cost. Market supply curve is obtained by horizontally summing up the individual supply curves. A cost saving technological progress shifts the marginal cost curve down and hence shifts the supply curve to the right. An increase in the price of a substitute good in production shifts the supply curve of the product in question to the left.. but only in the short run. The price line facing a competitive firm is horizontal because this firm is a price taker.80 INTRODUCTORY MICROECONOMICS industries due to computerisation will lead to more employment. The profit-maximising condition.e. In the worst case. The price line is also interpreted as the demand curve facing a competitive firm. there may be employment costs of computerisation. An increase in input prices shifts the marginal cost curve up and hence shifts the supply curve to the left. On the other hand. A firm’s supply curve consists of the rising portion of its marginal cost curve. In general. forms the basis of the supply curve. a firm’s profit maximising condition is that marginal revenue is equal to marginal cost. Increasing marginal cost explains the law of supply or why the supply curve is upward sloping. there are major long-run benefits. An increase in the rate of the excise duty shifts the supply curve to the left. . 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. In summary.
6 4.8 4. Price elasticity of supply measures the responsiveness of quantity supplied to a change in its own price. During the market period. 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? 4.12 4. the marginal costs of production of televisions have gone down.13 . 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.3 4. A straight line supply curve which intersects the x-axis in its negative range implies price elasticity of supply greater than one.9 4. EXERCISES Section I 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. the individual and the industry supply curves are vertical.1 4.REVENUES. 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.2 4.11 4.7 4. A straight line supply curve passing through the origin implies price elasticity equal to one.5 4.4 4. irrespective how steep or flat it is.
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 4.17 4. (b) Suppose the market price increases to Rs. 17.22 4. (a) Derive its total revenue schedule for the range of output from 0 to 10 units.15 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.18 4.21 4. Quantity Sold 1 2 3 4 5 6 7 TR MR AR 4.24 4. 5. 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. 15. A perfectly competitive firm faces market price equal to Rs.25 4.19 If a farmer grows rice and wheat.16 4.14 4.20 4.26 .82 INTRODUCTORY MICROECONOMICS 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.
34 4. How will this affect the supply curve of stainless steel utensils? Because of cyclone in a coastal area. PRODUCER'S EQUILIBRIUM AND THE SUPPLY CURVE 83 4.) 7 14 21 28 35 4.27 A firm’s TR schedule is given in the following table.) — 37 40 44 48 Firm B (kg.) 100 — 135 154 — . 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.) 20 30 — 50 60 Firm C (kg.33 4.REVENUES. the sea level.28 4.31 4.) 45 50 55 — 65 Market (kg. This reduces the productivity of land.30 4.) 1 2 3 4 5 Firm A (kg. How will it affect the supply curve of rice of that region? Consider the following individual and market supply schedules.36 Why is AR always equal to MR for a competitive firm? Name three factors that can shift a supply curve. What is the product price facing the firm? Output 1 2 3 4 5 TR (Rs.35 4. covers a lot of rice fields. Price (in Rs. Give two examples where technological progress leads to a shift in the supply curve./kg.29 4.32 4.
Rank their price elasticities.84 INTRODUCTORY MICROECONOMICS (a) 4. 3. 4. 2 to Rs. (b) Plot the supply curve of each firm and the market supply curve in a single diagram.38 The above diagram shows the supply curve of 3 commodities. . Section III 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.39 Show that the rising portion of the marginal cost curve is the supply curve of a competitive firm.37 Complete the above table on quantities of potatoes supplied by the firms and the market. Draw straight line supply curves with (a) unitary price elasticity and (b) zero price elasticity.
PRICE DETERMINATION UNDER PERFECT COMPETITION 85 U N I T.I V FORMS OF MARKET AND PRICE DETERMINATION .
5.86 INTRODUCTORY MICROECONOMICS CHAPTER 5 PRICE DETERMINATION UNDER PERFECT COMPETITION 5. The question is: which price will prevail in the market? Suppose that. 5. It depicts the market demand and supply curves of a particular product. But they do not tell us what the actual price of the product will be (in principle) or. in other words.1 MARKET EQUILIBRIUM AND DETERMINATION OF PRICE AND QUANTITY Consider fig. initially.6 Efficiency of the Price Mechanism and Competitive Markets 5.7 Economic Policy by the Government and Market Equilibrium • • • • • • • The foundations underlying the demand and supply curves were laid in Chapters 2 and 4 respectively. denoted respectively by DD and SS.4 Sources of Supply Shifts 5.3 Sources of Demand Shifts 5. The emphasis is on applications. the price . You will see that there are not many new concepts or definitions to be learnt. what points on the demand or the supply curve will be actually chosen in the market place. This issue is addressed in this chapter by pooling together what we have learnt about the demand and supply. These curves respectively tell us how much consumers demand and how much producers supply at different prices.1.1 Market Equilibrium and Determination of Price and Quantity 5. 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. A number of examples will be provided as we proceed.5 Anatomy of Famines 5.2 Demand and Supply Shifts 5.
1. It is indicated by the arrow. This is how price and quantity are determined in the market. This is indicated by the upward-looking arrow. it is defined by the equality between quantity demanded and quantity supplied. There is excess demand. it is shown at the point E0. say. The quantity demanded (D3) is less than the quantity supplied (Q3). Where will the price finally settle? The answer is again P0. the consumers demand the quantity D1 and the producers supply the quantity Q1. The equilibrium quantity sold/purchased is 6. The price P0 is 1 called the equilibrium price. Indeed.PRICE DETERMINATION UNDER PERFECT COMPETITION 87 in the market for that good is P1. pointing downwards. It will increase. which gives the demand and supply schedules of bananas (in a given geographical location and within a given time period). 5. 5. Finally it will converge to PO. In fig. Recall that equilibrium means a position of rest. The equilibrium price is Rs. The term “excess demand” here refers to a particular commodity or service. since at this price quantity demanded matches with quantity supplied. The equilibrium quantity exchanged (between consumers and producers) is equal to Q0. excess demand will create competition among the buyers and push the price up. consider Table 5. At this price. equal to D3 Q3 which will create competition among the sellers and lower the price. there is a mismatch.1 Will then the price stay at P1? No. the market “rests” at price P0 in the sense that there is no pressure on price to either increase or decrease.1 Market Equilibrium As a numerical example.1. Here. Alternatively. The price will keep falling as long as there is an excess supply. The situation of zero excess demand and zer o excess supply defines market equilibrium. 5. Obviously. Fig. . There is excess supply. Thus price will increase further. at which there is no excess supply. Excess demand is present at this price also. Consumers want more than what the producers are willing to supply. This is different from what is meant by “excess demand” in macroeconomics. the price will keep increasing as long as there is an excess demand. at which there is no excess demand. The corresponding demand and supply curves and market equilibrium are shown in fig. Just the opposite happens if initially the price is P3.000 dozens. 21. equal to AB or Q1D1.2. to P2.
. 5. however. What does this mean? This means that the product in question will not be produced in the economy.3 occurs: the demand curve and the supply curve do not intersect with each other at any positive quantity. which is not viable in one country. The industry is not economically “viable”. commercial aircraft is such an example.) 18 19 20 21 22 23 Fig.2 Market Equilibrium Corresponding to Table 5.500 Price of Bananas per dozen (in Rs.88 INTRODUCTORY MICROECONOMICS Table 5. Put differently. 5.000 7.000 6. it is not produced at all. commercial aircrafts are produced in America..000 4.000 8. not produced at all in India.000 5. an industry.e.1 which any positive amount can be supplied is higher than what the consumers are willing to pay.500 8.500 Quantity Supplied (in dozen) 1.000 2.000 4. Supply and Equilibrium Quantity Demanded (in dozen) 10. 5. Of course.000 7. costs are too high for any positive output to be produced.1 An Example of Demand.3 A Non-Viable Industry Computer memory chips. mother boards and copying machines are other examples. The price at 2 Fig. These are totally imported. quite possible that a situation such as in fig. Britain and France.2 It is. can be viable in some other. In India and many other countries. For example.000 6. i. Russia.
Without going into what causes a shift.2 DEMAND AND SUPPLY SHIFTS For any given product in the real world.2 Demand Shifts (a) (b) Fig. The new price and quantities are P1 and Q1 respectively. the supply curve or both. 5. The same computer will sell for much less. Now let the demand curve shift to the right. as shown by DD1. Some of you must have shopped for fruits and vegetables for your family or for yourself. Changes in those factors explain price and quantity changes.2. Apples sell for less in some seasons than in others. 5. Goods and services for which fig. 5. price and quantity exchanged change from time to time. 5. a rightward shift of the demand curve moves the consumption point from E0 along DD0 to A along DD1. Thus both price and quantity increase. say. 5. 5. we first discuss how a demand or a supply shift will affect price and quantity. 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.1 and 5. 30. Rs. the initial price and quantity are respectively P0 and Q0.1 we also know the quantity that will be produced and the price that will be charged in equilibrium. Those for which fig.3 illustrate how the “what” problem of an economy is solved by market mechanism. The same cauliflower.4(a). for example. The analysis of demand and supply curves and the market equilibrium provides the framework to explain such changes. costs less in the winter than in the summer. Accordingly. from fig. 5. . 5. We see immediately that the equilibrium point shifts from E0 to E1.4 Demand Shifts Turn to fig. We already know in Chapters 2 and 4 how various factors cause shifts in these curves.4(a)]. Given that a good is produced. six months after.1 applies are.000. Let the initial demand and supply curves be DD0 and SS0 respectively. How? Through shifts in the demand curve.3 applies are not produced. 5. A computer for a given configuration sells in your town for.PRICE DETERMINATION UNDER PERFECT COMPETITION 89 Figs.
an increase in supply causes an excess supply in the market.90 INTRODUCTORY MICROECONOMICS This creates an excess demand. 5. While there is a change in demand. The new price and quantity are P1 and Q1. shown in fig. In turn. producers however operate on the same supply curve. In panel (a) the original demand It is possible that both demand and supply shifts occur simultaneously. while the . not a change in supply.5. as shown in fig 5.2. This causes the price to fall and the new price settles at a level that is less than the original price. The new equilibrium point is E1. Then the market price may increase or decrease. and supply curves are denoted again as DD 0 and SS 0. The opposite happens if both curves shift to the left.5 (b) 5. it causes price to increase. and. Why? At the original price P0. Suppose the supply curve shifts to the right to SS1. For example. if the demand curve shifts to the right and the supply curve to the left. We see that the price decreases and the quantity increases.4 Simultaneous Demand and Supply Shifts (a) Fig. but the quantity exchanged will increase unambiguously. 5. the decrease in price leads to a downward movement along the demand curve. Since the demand curve remains the same.2. a leftward shift of the demand curve will lower the equilibrium price and quantity. More quantity is demanded and in equilibrium more is produced. equal to Q0Q'. E 0 is the original equilibrium point. Hence. there is a change in the quantity supplied. hence the new price settles at a higher level.2. The effects of a leftward shift of the supply curve cause rise in price and fall in quality as shown in Fig. At a higher price they supply more quantity.3 Supply Shifts Now consider supply shifts. Similarly.4(b). 5. the demand and supply curves both shift to the right. This explains why the new quantity exchanged is greater. Their net impact on price and quantity will be a combination of 1 and 2 in Table 5. the market price will unambiguously increase. Likewise.5 (b) Supply Shifts 5.
” Touchdown India. by using Table 5. tastes or size of the market. prices of related goods. 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.000 crores of rupees. Therefore. We know from Chapter 2 that. undated. the demand curve for it shifts to the right. an increase (a decrease) in income leads to increases (decreases) in the price and quantity exchanged. An estimated 16 lakh Keralites were working in the Middle Eastern countries and they brought. Kottayam. Example 5.4(b) then applies: both price and quantity fall. 5. annually. For a decrease in income fig.3. as long as a product is normal. we know that an increase in income shifts the demand curve to the left. 5.4(a) applies. 5. their effects of price and quantity. Both price and quantity increase. Chalakudi and Chavakkad. Both market price and quantity fall.3 SOURCES OF DEMAND SHIFTS Recall from Chapter 2 that the market demand curve can shift because of changes in income.4(b) applies.4 Example 5. 2. as the Japanese economy was growing strongly. “Highrise Hungama. Fig. for a normal good. Instead.PRICE DETERMINATION UNDER PERFECT COMPETITION 91 Table 5. In some places the land price almost trippled in two years. Fig. 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. 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. This is based on Sonali Mujumdar. foreign exchange worth of 700 to 1. The opposite happens if the demand curve shifts to the left and the supply curve to the right.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. It was not because there was a massive industrialisation or an unusual population explosion in these areas.1 A Change in Income If it is an inferior good.1 Market for Real Estate in Kerala. various name 4 Air India even operated special flights from Trivandrum to the Middle East to accommodate the increased traffic. quantity exchanged may increase or decrease. ▲ . the reason was that a lot of Keralites from these areas moved to the Middle East countries to work and earned substantial income there. 5. flats etc. We analyse each of these in turn.2. In this period. This shifted out the market demand curve for housing in urban Kerala. and.2 Japan in late 1980s and early 1990s. 3 Think of the market for land.2 Summary of Demand and Supply Shift Effects 1. We return now to demand and supply shifts one at a time. examine their causes. especially in towns like Cochin. T richur.
compared to 66. Suppose the price of tea goes up. we know that. Suppose the price of coffee rises for some reason. 1996. 1997 and 1998 respectively). and. 8th Edition.” 1994.jetro. This will definitely generate a 6 7 See William Baumol and Alan Blinder. Harcourt College Publishers.4(b). the price of Brazilian coffee in the world market shot up and it remained high in the next few years.92 brand products became the outlet for rising income. http://www. 1997 and 1998. However. the prices and quantities sold of these items in Japan soared. It remained high for the next four years ($1. As a result. http://www. the price of a given product rises and its quantity exchanged increases.4(a) applies then. Also see JETRO (Japan External Trade Organization). $1.jp/it/e/pub. But imagine that medical research shows that eating 100 grams of bitter gourd per day prevents pimples on the face. ▲ ▲ . As a result. we find that the price of sugar as well 5 5.36 cents. In the New York wholesale market. Hence. Economics: Principles and Policy.46. kalara in Oriya and Pavakkai in Tamil. tea being a substitute of coffee. the price of a given product and its quantity exchanged both decrease. The Data sources are the following.3 Prices of Coffee and Tea in the World Market in the Late 1990s. Brazilian coffee sold for $1.43/pound in 1994. namely.15 cents. the market for tea. 83.6 5.08 per pound for the years 1993. it was hit by two severe frosts. Applying fig. How does it affect the sugar market? From Chapter 2 again. 2000. 1996.58 cents in 1993. were 84. Unlike coffee and tea. Example 5. Fig. in 1998.e.67 and $1. the demand curve for tea will shift to the right. Brazil is a major producer in the world coffee market. as the price of a substitute good in consumption rises. page 80. $1. With a lag of two years. 74. i. This can be interpreted as a delayed effect of an increase in the price of coffee on demand for tea. it is the web site of UK Tea Council.3.5 INTRODUCTORY MICROECONOMICS ▲ as its quantity will fall. the wholesale tea prices. 80. as the price of a complementary good increases.2 A Change in the Price of a Related Good in Consumption Take for instance. 5. 1995. The price of tea rises and so does the quantity of tea exchanged.22 in 1995.go.3 A Change in Tastes Think about the market for bitter gourd. 5. In 1994. the demand curve for it shifts to the left.20 cents. there was an increase in demand for Levi’s jeans and Nike shoes. International Financial Statistics Yearbook 2000.3. sugar consumption is complementary to tea. For example. it more than doubled. This is called karela in Hindi. “The Japanese Consumer: From Boom to Reality. Observe that the tea price went up particularly in 1997 and 1998. During the same time period. the price of tea in the world market also jumped up (while the production of tea was still growing).uk.20. which damaged more than half of its coffee trees.46 cents. 1994. Thus.teacouncil. the world production of tea in 1997 was 2% higher than that in 1996. as quoted in the London auction market.7 Surely it is not a very popular vegetable in your age group.co. $1. it was 11% higher than it was in 1997. From our analysis of demand shifts in Chapter 2.08 and $1. For tea production. it is International Monetary Fund. For coffee and tea prices.
This can be interpreted as an increase in market size for land in Delhi. This was primarily due to the huge migration of people from Asian countries. in 1990 to nearly 3.3. which pushed up the land price in Delhi. there was a substantial increase in land price in Delhi. by and large. Many airlines had to reduce their scales of operation drastically. a favourable (an unfavourable) change in taste will cause product price and quantity exchanged to increase (decrease). ▲ ▲ change in your food habits. migration from overseas contributed 79% to the net population growth of Vancouver. on the average. Likewise.8 Many of you will start to eat more bitter gourd than before. Overall. 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. The source of this material is David Ley and Judith Tutchener. 2001. on the average. Vancouver Centre of Excellence.6 House Price Rise in Vancouver. whereas a decrease in the population will do the opposite.PRICE DETERMINATION UNDER PERFECT COMPETITION 93 Example 5. 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. Thus. a decline in liking for a product will cause opposite changes. We can use fig.2 lakh Canadian dollars. many people became afraid of flying. After the terrorist attacks in America on September 11. They were. wealthy. ▲ ▲ ▲ . which would shift the demand curve for air travel to the left.4 Market for Air Travel.5 Land Price Increase in Delhi in 1980s.4(a). Example 5.4 A Change in Market Size By now you should know immediately how this affects price and quantity. it means a change in demand due to reasons other than price or income changes. This can be thought of as an adverse change in tastes due to fear of flying. 5. Compared to 1970s. and deduce that price of bitter gourd as well as the total quantity produced and consumed of it will increase. in 1995. Example 5. Most of those who came to Canada settled in Vancouver. there was a major decline in the ticket price of air travel within America and a large decrease in the number of passengers.10 ▲ Recall that a change in taste does not only include a change in taste in one’s mouth. quantity. March 1999. during 1990-1995. Consider air travel.” Research on Immigration and Integration in the Metropolis Working Paper Series. The market demand curve will shift out. “Immigration and Metropolitan House Prices in Canada. Canada. especially from Hong Kong. It was because of large scale migration of people from Punjab to Delhi following disturbances in Punjab in the mid 1980s. Shortly after that day. 5. These things did happen.08 lakh Canadian dollars. The price of air tickets would fall and less number of people would travel.9 Their demand for housing was the main factor behind the house price surge there during the period 1990-1995.
These cafes have sprawled in many cities. A year later in 2001. As a result. Example 5. big and small.7 Micro-computer CPUs. 5.000. all over India. A 15" colour monitor used to cost around Rs. technological progress leads to a fall in price and an increase in quantity exchanged. 5. after being introduced in the market. Moreover. in Delhi an hourly 11 For example. a change in the number of firms shifts the market supply curve without affecting the individual supply curves.400 in 2000. at the time of writing this book. As you might know. inputs) that go into making a PC are becoming increasingly cheaper.94 INTRODUCTORY MICROECONOMICS 5.000. Example 5. For instance. in 2000. The case of CPU was discussed in Example 5.5(a) applies. the monitor and the printer) of given configurations goes down rapidly over time. Example 5.4 SOURCES OF SUPPLY SHIFTS In Chapter 4 we learnt that technological progress.5(a) and (b).9 Internet Café Rates in India. In the year 2000.4. 7.1 Technological Progress It shifts the supply curve to the right. Fig.e. the production of CPU has seen phenomenal technological progress. a 550 MHz CPU cost around Rs.4. my desk-top computer had a 550 MHz CPU in it. the brain of any micro-computer is its CPU. the product price decreases and the quantity rises or the price increases and the quantity falls according as an input price decreases or increases. Thus. It is a common observation now a days that the price of a PC system (the computer. 9. the CPU is placed inside a computer. ▲ This is a prime example of technological progress. It is because the components (i. whereas in Example 5. a CPU of a given speed becomes almost obsolete in a matter of 6 to 7 years. as an input price decreases or increases. the technological progress is so rapid that. Note carefully that Example 5.2 Change in Input Prices From Chapter 4 we know that the supply curve shifts to the right or left. sometimes less. 8.11 Over the last few decades. it came down to about Rs. Other components of a computer system are becoming cheaper also. ▲ ▲ ▲ ▲ . In 2001.5 square inches in size only. 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. Its speed (similar to the speed of brain) is given in a MHz rating. Indeed. the Central Processing Unit.7.8 the product price decreases because of decrease in input prices. 5. 14.000. in view of figs. we see the price of a CPU of a given speed going down rapidly over time. it was selling at around Rs. Therefore.7 was about a decrease in input price due to technological progress.8 Personal Computers. changes in input prices. About 1. 5.
Satyam etc. Second. i. 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.4. 12 This is because of reduction in input prices. there were initially two companies: AirTel and Essar.. HLL reduced prices across a variety of brands including Clinic and Sunsilk shampoos. as the excise duty rate increases (decreases). 16% earlier. The charges for outgoing and incoming calls were quite high. Pond’s talc and Lakme make-up products. went down. less competition does the opposite. it came down to an average Rs. in connecting to the ISPs.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. as there is more or less competition in terms of the number of firms.PRICE DETERMINATION UNDER PERFECT COMPETITION rate for internet “surfing” was no less than Rs. the internet access charges to these cafes by ISPs (Internet Service Providers) such as VSNL (Videsh Sanchar Nigam Limited).5 then.e. Applying fig. For example. 5. the market supply curve can if the number of suppliers in the market changes. 5.4. First. major companies like Hindustan Livers Ltd. price falls and quantity rises or price rises and quantity falls. Godrej and Proctor and Gamble (P & G) reduced prices in this category of products. 5. 5. cable lines could be used.5(a) and (b). By the end of 2002. Example 5. from figs. which are cheaper and through which the connection can be kept uninterrupted for 24 hours a day. and In the union budget of 2002-2003. we saw that an increase (decrease) in the excise duty rates shifts the supply curve to the left (right). From fig. Example 5. Thus.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. no less than Rs. there . ▲ ▲ ▲ Mobile phones came to the four major cities of India in the mid 1990s. (HLL).11 Mobile Phone Rates.5 Number of Firms Even when the individual supply curve does not shift. Third. In 2002. As soon as it happened. 5. it follows that the price of the product will increase (decrease) and quantity transacted will decrease (increase). In Delhi. Pond’s skin creams. was completely removed.4. A decrease in the number of firms. the price of computers came down. 50. the special excise duty on cosmetics and toiletories.10 Cosmetics Toiletories in 2002. 95 5. 15 per minute. ▲ 12 This rates were found from the author’s own survey.3 Change in Excise In Chapter 4. instead of phone lines. 15 in many such cafes.
it is the entry of new firms. analytically. flood etc. an estimated 16 lakh people died. Hutchison's Hutch (which acquired Essar).. Example 5. Incoming calls in some schemes are even free. tea or computers.12 (In)Famous Onion Price Increase in 1998. famine can be seen as a massive incidence of starvation.6 Other Factors Factors like weather. a large portion of a region’s population Although the mobile phone market has only a few number of firms. We can define total availability of a product as the amount produced plus the amount stored in government and private warehouses.5 ANATOMY OF FAMINES: AN APPLICATION OF THE DEMANDSUPPLY ANALYSIS The reach of demand-supply analysis is quite far and deep. it became a very politically sensitive issue. which is a contributing factor in the decline of mobile phone charges. The mobile phone rates have come down drastically.13 Epidemics typically result from large scale starvation. Onion being a very common vegetable. which caused a drastic decrease in supply of onions to the market in that year. For reasons like natural calamities and unfavourable weather over critical months. variation in agricultural output in India from one year to the next is dependent partly on how good the monsoons are. we apply it to understand how famines occur. A famine is characterised by widespread death due to starvation and epidemics. natural disasters such as cyclone. In this section. starvation is reflected mostly in the staple food of the region. A specific example of this and its effect on price is given below. Not only it explains what happens in the market for products like coffee. not many as in a perfectly competitive market.96 were four companies : Bharati's AirTel. the total production of the staple food is severely affected. which are results of Nature’s play. can also affect the supply of a product. MTNL's Dolphin and Tata-Birla -AT & T's Idea. The standard view is that it is primarily a production or “total availability” problem. In turn. consumed by most households. 13 In the Bengal Famine of 1943 for example. which drastically limits the total availability. Hence. For instance. one of the worst famines of the 20th century. Therefore. INTRODUCTORY MICROECONOMICS 5.4. ▲ In October -November of 1998. As a result. 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. 5. ▲ ▲ . the onion price in India increased 6 to 10 times from its usual price. The reason behind this unprecedented onion price rise was heavy rains and flooding in the onion growing areas in India. it can shed light on very complex socio-economic issues.
all families are able to buy rice. Appendix 3 illustrates his theory in terms of the demand-supply analysis. Oxford University Press. curve intersects the price axis. If the price of rice is p3 or higher no one can buy rice. the only Nobel laureate in economics in Asia thus far. its quantity 16 demanded is C2. As shown. B and C respectively buy 15 16 17 The material on FAD theory and Sen’s own theory is based on Sen. At this price. The former demands the amount B1. Professor Sen’s own theory of famines is different. let the total available amount initially be M0. Indian Statistical Institute. which depicts the individual and market demand curves for rice as well as the market supply curve of rice. A. The resulting curve will look similar to DDM. If the market price is p2 the A. Let us say that there are three families. For those who are interested.. Panel (d) depicts the market demand curve. The types A. the market demand curve is obtained by horizontally summing the demand curves of all families.6.PRICE DETERMINATION UNDER PERFECT COMPETITION 97 does not get the minimum amount for survival and there is a large-scale starvation. Professor Amartya Sen of India. the A-type family’s quantity demanded is zero. Hence. Turn to fig. the B-type as the next poorest and the C-type. the A-type family cannot afford to buy any rice at all. We can instead draw a standard upward sloping supply curve. But this will not change the analysis. A. But it is not a major assumption at all. but such a price cannot prevail in equilibrium and hence is irrelevant.1 The FAD Theory Let the staple food be called rice. In what follows. Poverty and Famines: An Essay on Entitlement and Deprivation. B and C. decide to study economics further in college and eventually bag Nobel prizes for India. based on “Theories of Famine: An Exposition”. 1981. It is drawn vertical to represent that. after the harvest. 5. this is the total. (b) and (c) graph their demand curves respectively. . We can interpret the A-type as the poorest.14 See Clip 5-1 for a short bio-sketch of Amartya Sen. mimeo. The demand-supply version of these theories is the author’s own copyrighted work. but the B-type or the C-type family can. the FAD theory is illustrated in terms of the demandsupply analysis. calls this the FAD theory.5. potential amount available for consumption. the “richest”. This graph assumes that there is one family of each type. in the market. If there are two or more families of any given type.and B-type families cannot buy rice but the C-type can. this price is above the point at which the DDA. April 2002.K. DD M as the horizontal summation of the three individual demand curves. with FAD standing for food availability decline. This is not true for the B-type or the C-type family. 15 5. and the latter the amount C1. The panels (a). 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.17 The equilibrium price is then p0. From the supply side. It is hoped that some of you will be inspired. 14 Note that when the price of rice is p1.
equal to M1. In awarding him the Nobel prize in 1998.g. If. This situation can be interpreted as “normal”. 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. which is the highest civilian award in India. equal to p1. Oxford University. Currently. He was born in Santiniketan in 1933. London School of Economics and Harvard University. We can interpret this as a situation of famine or massive starvation. particularly welfare economics. His contributions range from axiomatic theory of social choice. from Cambridge University in 1959.D. there is less amount available. 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 C0. He has received more than forty honorary doctorates from major universities around the world. Notice that at this price.98 INTRODUCTORY MICROECONOMICS CLIP 5-1 By now Professor Amartya Sen is a household name in India. Since then he has held faculty positions in various prestigious institutions at home and abroad such as Delhi School of Economics. he is the Master of Trinity College at Cambridge University. the total available amount were much less compared to the initial situation. The equilibrium price is higher. and philosophy.” A0. e. 5. say. at this time of writing. and the Bharat Ratna award.6 FAD Theory of Famines . equal to M2. and. Whether exactly two types Fig. He studied in Calcutta University and later got his Ph. instead. B0. Now suppose that. over definitions of welfare and poverty indices. to empirical studies of famine. 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. the poorest cannot afford to buy any rice. one in which there is no starvation or famine. but the other types can. for some reason. his research has ranged over many areas of economics. He has published numerous books and articles. because of a bad monsoon.
PRICE DETERMINATION UNDER PERFECT COMPETITION
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.
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
(b) Price Control and Price Support
For example, in Delhi, the sales tax on pastries in the financial year 2001-2002 was 8% and that on bicycles was 5%. In general sales taxes vary across states and range typically from 5 to 15%. Some commodities are totally exempt from sales taxes. This is similar to the famine theory discussed earlier.
PRICE DETERMINATION UNDER PERFECT COMPETITION
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
Excess demand pushes up the market price by causing competition among the buyers. Excess supply pushes down the market price by causing competition among the sellers. At the market equilibrium, there is no excess demand or excess supply and demand and supply curves intersect. A non-viable industry is one, in which the demand and supply curves do not intersect at any positive level of output. The supply curve lies above the demand curve and thus nothing is produced. A rightward (leftward) shift of the demand curve leads to an increase (a decrease) in price and quantity transacted.
While the intentions behind price control and price support programmes are well-meant, there is considerable debate in economics literature about their efficiency in achieving the objectives, in comparison to other policies that can achieve the same objectives. This is something that will be studied in specialised courses in economics. World Trade Organisation is an international body like United Nations, having more than 120 member countries, whose objective is to promote free and fair international trade and commerce in the world economy. It came to existence in 1995 and is headquartered in Geneva, Switzerland. India is a founding member of WTO. China joined WTO in 2001.
1 5. The demand-supply equilibrium in a free market can be seen as co-ordination between consumers and producers. the price rises but the effect on quantity exchanged is unclear. as the available quantity of foodgrains falls. An increase in an input price leads to a higher price and less quantity being sold. This causes starvation. such that families in the lower end of wealth and income can no longer afford to buy it. the effect on price is ambiguous but the equilibrium quantity exchanged increases (decreases). If both the demand and supply curves shift to the right (left). 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. An increase in income results in a higher (a lower) price and quantity transacted according as the good is normal (inferior). which is purchased by the government. According to the FAD theory of famines. 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. EXERCISES Section I 5. the price of foodgrains increases.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. Give the meaning of excess supply of a product. A favourable (an unfavourable) taste shift leads to a higher (a lower) price and quantity transacted.2 5. If the demand curve shifts to the right and the supply curve to the left. 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.4 Give the meaning of excess demand for a product.3 5. A cost reducing technological progress leads to a lower price and more quantity being sold. 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. It also leads to black marketing. Give the meaning of equilibrium price.
12 5.11 5.6 5.22 .20 5.16 5.7 5.19 5.5 5.9 5.18 Show the determination of market equilibrium with the help of demand and supply schedules and a diagram.8 5.14 5. 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. Analyse how will it affect the market price of wheat. 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.” Comment. At the same time.15 For a non-viable industry.PRICE DETERMINATION UNDER PERFECT COMPETITION 103 5. because of an increase in the price of cotton.21 5. Suppose the demand for jeans increases. the supply of jeans decreases.10 5.17 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.13 5. 5.
31 How are decisions taken by consumers and producers in a market co-ordinated? Trace the effect of demand shifts on equilibrium price and quantity. Defend or refute. ceteris paribus. which means that it can sell its product in other member countries like India. the Supreme Court of India banned smoking in public places. .24 5. demand rises. to Rs. 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. Consider their effects on the market for new cars.30 5. Suppose that it does export a large number of telephone instruments to India.23 5. 2 per kg. How will it affect India’s total expenditure on telephone instruments? In the union budget for year 2002-2003. how will it affect the market price of tea? Suppose the price controls on sugar are lifted.26 5. but as demand rises. Ramgopal says that economists say inconsistent things: as price falls. It has recently become a member of WTO. How. Given one example each of direct intervention and indirect intervention in the market mechanism. All other things remaining unchanged. Answer all questions in terms of shifts in or movements along the demand and supply curves. Describe the FAD theory of famines. 1 per kg (this is a fact).27 5.104 INTRODUCTORY MICROECONOMICS 5.29 5. (a) In 2001. price rises. (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.25 5. the excise duty on tea was reduced from Rs.28 5. How would it affect the price of drugs? China is a big manufacturer of telephone instruments. (c) New environmental regulations require that the drug industry use a more environment-friendly technology whose running costs are higher but which discharges less toxic chemicals than before. How 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. will it affect the price and quantity consumed of sugar? Section III 5.32 5.33 Mrs.
we analyse the first two. monopolistic competition and oligopoly. 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. There are three broad forms of imperfectly competitive markets: monopoly. There are other market structures. (b) the product is homogeneous and (c) there is free entry and exit of firms in the long run. . and. In this chapter we study market structures as such. Having already analysed the implications of (a) and (b) under perfect competition.3 Monopolistic Competition The notion of market structure was introduced in Chapter 4. i. given that the objective of a firm is to maximise profits. perfect competition in the long run. we begin by analysing the implications of feature (c). learnt how the price/market mechanism works. 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. In Chapter 4 we saw how (a) and (b) lead to the supply curve. which are not perfectly competitive.2 Monopoly 6. They go under the name of imperfect competition or imperfectly competitive market. In this chapter..e.1 Perfect Competition in the Long Run: Free Entry and Exit 6.
Suppose that the market price of the product is P1. This is the break-even price. negative profits. This will shift the market supply curve to the right. we discuss a couple of things. Note that profit being zero is equivalent to P = LMC .1 PERFECT COMPETITION IN THE LONG RUN: FREE ENTRY AND EXIT Before analysing the implications of free entry and exit. implies the U-shape of LMC curve. initially. a positive profit is sometimes referred to as abnormal profit. in the sense that the total cost is assumed to include not just the production costs but also the opportunity cost of the producer herself − and hence profits are equal to the producer’s excess earning over her opportunity cost. The pattern of returns to scale − that is. in turn. that is. initially at low levels of output. at the profitmaximising level of output. How far will this continue? It will happen till there are no abnormal profits. This will tend to shift the market supply curve to the left. abnormal profits will attract many new firms to the industry.) In this situation. the long-run competitive equilibrium is then defined by P = LMC = LAC. (Likewise. In economics. followed by constant returns to scale and diminishing returns to scale − implies the U-shape of LAC curve. 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. a firm would experience increasing returns to scale. The exit process will continue till there are no losses. the price is low enough such that firms are incurring losses. The economic logic behind it is also parallel to that in the short run.106 INTRODUCTORY MICROECONOMICS 6. Recall from Chapter 3 that there are no fixed costs in the long run. We are now ready to examine the effects of free entry and exit. which will lower price and profits. suppose that the price. P1. The price will rise. free exit means that some existing firms will start to quit the industry. and the firms are producing at the point where the price line intersects the LMC curve. 1. is high enough such that. Another way to look at it is that there will be more competition. We can then say that free entry and exit imply that in the long run the market price will be equal to the break-even price. Together with the profit maximising condition P = LMC. losses are called abnormal losses. both the Long run Average Cost (LAC) and the Long run Marginal Cost (LMC) curve are U-shaped. Similarly. if. It then follows that free entry and exit imply zero profit in equilibrium. 2. Profit is maximised when P = LMC. Losses will be less. Moreover. driving down the market price and profits. . firms are making positive profits. Moreover. which. the price at which the abnormal profit is zero.
“Mono” means “one”. both the marginal cost and the average cost are equal to the price pL. The total equilibrium quantity produced and exchanged is QL . Market equilibrium occurs at price pL. To take another instance. you hear many people use the term “xeroxing” (a) (b) Fig. Abnormal profits are zero. See Exercise 6. transmission and distribution of electricity were in the hands of State Electricity Boards (SEBs). not too many or too few. it is not possible to see what this number is in this diagram. but it is not that large so as to incur the problems associated with decreasing returns to scale. i. before liberalisation in the power sector got underway in the 1990s. 6. firms are in equilibrium (i. That is.1(b) depicts the long-run market supply curve (with the number of firms being equal to its equilibrium value) and the demand curve. they are maximising profits) and there is no entry or exit. the firm produces at a level (qL). There is an important property associated with a perfectly competitive market in the long run equilibrium. Fig. as price equals average cost.2 MONOPOLY Some of you must have heard this term before. production occurs at the most efficient scale. However. 6. The SEBs were monopolies in the respective states. 6. “poly” means “seller” and thus “monopoly” means one seller.1 Firm and Market Equilibrium in the Long Run ..where the LAC is at the minimum. Panel (a) shows that a firm produces the output qL. 6.1. This is defined in the context of a given geographical location or space.47 for a numerical solution. which is consistent with profits being zero.e. at the long run equilibrium. Implicit in this panel is that there is an equilibrium number of firms.OTHER FORMS OF MARKET STRUCTURE 107 That is. The firm’s scale of operation is large enough such that the benefits of increasing returns to scale have been realised. the generation. This is illustrated in fig. At this level of output. In India.e.
As a result. In India. patents are being protected more aggressively than before. http://www. The most important patent legislation in India is the Indian Patent Act of 1970. who may be using its technology without a license. and many poor people will be denied access to these drugs. But it explicitly did not allow product patents in the drug and food sector. we are forced to honour patent protection. However.wto. To continue our account of Cipla selling Combivir in Ghana. This is because research and development. e. as an obligation of being a member of WTO (World Trade Organisation). Indian companies will no longer be able to sell many essential drugs at affordable prices. 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. During the patent life the patent holder can sell license to other firms for using its technology (legally). . and get a fairly quick decision.g. a major amendment to the Patent Act of 1970 was done in 1999. is patentable. India and other countries had to revamp their patent laws. to a country like Ghana. There is a fear in India that. In general. 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. we generally import technology from abroad. 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. It provided that any invention of a new product or a process of production. This allowed Indian drug companies to produce drugs invented in the developed countries and sell them in less developed countries. Cipla. named Combivir. the patent law and its enforcement are rather passive. the drug prices are going to skyrocket.108 INTRODUCTORY MICROECONOMICS CLIP 6. by which both product and process patents are allowable in the food and drugs sector. discoveries and inventions have not been a focus of activities by firms.org and read many articles on these issues. Cipla has supplied antiAIDS drugs. in a different country. is an example. an Indian drug company. We recommend you to visit WTO’s website. For a long time. After the hearing of arguments by both companies. a careful and rational thinking might suggest just the opposite. particularly in the drug sector. Recently however.1 Patent Laws Most developed countries have comprehensive patent laws. A patent holder can take to court some other firm. Barring a few exceptions. because of our being a member of WTO. which is useful and not obvious. the government of Ghana in 2000 rejected Cipla’s application to market this drug in Ghana. Once multinational companies start to sell them. In India.. Typically.
which discovered the plain-paper photocopying machine in 1959.2 However. In Australia it is 20 years. patents are not granted for ever. This period is called patent life. 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. A monopoly market structure emerges because of any of the following reasons. Canon. till 2002. This patent is supposed to expire in 2003. Sharp and Toshiba. For instance. See Clip 6-1 on patent laws. The case of Xerox is an example. 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. they can apply to their government for a patent. In most developed countries the patent life varies between 15 to 20 years. This is called a cartel.. Another example is a drug company called Eli Lilly. Ricoh. It obtained patent on it. It is implicit that there are no close substitutes to the monopoly’s product or service available in the market. fir ms retain their individual identity but they coordinate their outputs and pricing policy so as to act as if it is a monopoly. As a reward for their risk and investment in research. It is also implicit that there is no free entry (otherwise. e. (c) Sometimes. Actually. Royal. in the U. VSNL (Videsh Sanchar Nigam Limited) had monopoly in India in providing international telephony service.) Throughout the 1960s it was the only company that manufactured and sold plain-paper photocopying machines. . (The concept of patent will be explained shortly.S. Mita. A monopoly is the opposite of the per fectly competitive market structure: there is just one firm/seller instead of many. (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. monopoly arises because of granting patent certificate or what is called patent rights. There is little competition.g. (a) The government gives license to only one company for producing a product or providing a service in a given locality or space. Now there are many well-known companies. Panasonic. it is currently 17 years. in the world market that produce photocopying machines. which has a patent on a very widely used antidepressant called Prozac. Xerox is an American company. more than one firm can operate in the industry). In other words.OTHER FORMS OF MARKET STRUCTURE 109 to mean the use of a photocopying machine. They are valid only for a certain number of years (after which other firms can freely copy the technology). besides Xerox. Many fax machines also have copying capability.
It has market power and it is a price-maker so-to-speak. in the import-export market. Recall that a perfectly competitive firm is very small compared to the market.g. there are other countries which are major producers of oil.110 INTRODUCTORY MICROECONOMICS world market for oil. This is the most important difference of a monopoly firm from a perfectly competitive firm. marginal cost etc.g. merger and acquisition. Kuwait. followed by Indonesia and Libya in 1962. so as to manipulate the price of petrol in the world market. But the revenue structure facing the monopolist is quite different. The cost structure facing a monopolist is similar to that of a competitive firm.3 6. But its consumption is even greater and thus it is an importer of oil. In the 1970s when the first oil price shock overtook the world economy. Saudi Arabia and Venezuela. 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. For example. See Clip 6-2 for a brief history of the OPEC and the world oil market. another large tea firm.. It does not have any market power and thus it is a price-taker. e. total cost.) The aim of the OPEC countries is to set production quotas. None of this is true for a monopoly since it is the only producer by definition.. namely.. United Arab Emirates in 1967. America was and still is.1 Total. Hence. The oil shortage of 1970s motivated many other countries to explore oil. Algeria in 1969 and Nigeria in 1971. who were major exporters of oil and who used to be importers of oil earlier. By mid 1980s there were other countries. as output increases. OPEC consisted of the above-mentioned countries. Iraq. which. It left out Tata. (Currently there are two other countries in OPEC. In the early 1990s. e. and their general shapes are also the same as for a competitive firm. by definition. In case of the latter. we already know that. average cost. But a monopoly firm faces the entire market. Hence. Mexico. Average and Marginal Revenues The objective of a monopolist is to maximise its total profit. It came into existence in 1960. OPEC in the 1970s can be interpreted as a monopoly.2. a big producer of oil. the price remains unchanged. in the tea industry. hence faces the market demand curve. India also produces oil and is an importer. Besides the OPEC. We have the same concepts. . equals total revenue minus total cost. Brooke Bond and Lipton merged and subsequently they merged with Hindustan Lever. The Netherlands and Russia. Ecuador and Gabon. 3 There are other reasons for monopoly or near-monopoly also. It implies that the way total revenue changes as output changes is different from what happens to a perfectly competitive firm. Qatar joined it in 1961.
especially non-economists. she (the monopolist) must charge price equal to Rs. only if the demand curve were totally vertical. The monopolist has to take this into account. by multiplying output by price. 4 5 Hence. it can be argued that if the monopolist wants to produce and sell 5 units. defined as the addition to the total revenue from one extra unit sold. Moreover.) 1 3 5 7 9 11 13 15 Quantity Demanded (units) 7 6 5 4 3 2 1 0 shown in column (4). Since the monopolist faces this demand schedule it means that if she wants to sell 4 units for example. The reason is as follows. .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.e. AR = price × output/ output = price. the market demand curve is a constraint facing a monopoly firm. Now. The last column gives the MR schedule. TR/output = 0/0. These two columns represent the same demand schedule as in Table 6. unlike what many. since. cannot not just charge any price at its sweet will. This point must be understood very clearly. Therefore. as long as she wants to sell 4 units. AR. by definition. the price charged will be Rs.. she will be able to sell only less than 4 units. i. This is done along the first two columns in Table 6. It could have. there were absolutely no substitutes available. a monopolist despite having market power. Also recall from Chapter 4 the concept of Marginal Revenue (MR). Similarly.1 A Demand Schedule Price (in Rs.2. there is no reason to sell at any price less than Rs.1. This is true except when output is zero. and so on.1. starting with output equal to 0 (and corresponding price equal to Rs. TR being equal to price × output. AR = TR/output. This is Table 6. At zero output. 7. 7 each − because along the market demand curve 4 units are demanded at the price equal to Rs. Put differently. 5. If she charges any price higher than Rs. the market demand schedule is as given in Table 6. believe. But for most products substitutes are available. 7. which are given in column (3). that is.OTHER FORMS OF MARKET STRUCTURE 111 willing to pay along the demand curve. which is not defined. we get the Total Revenue (TR). she can sell them all by charging Rs. Suppose. 15). Dividing TR by output gives average revenue. 7.5 Thus the entries in column (4) are same as those in column (2). 7. AR is equal to price.
2 The TR. it means that. Since AR = price. TR increases or decreases as MR is positive or negative. MR decreases with the output.2 TR. Except for the first unit. 2.e. 6.112 INTRODUCTORY MICROECONOMICS We note the following properties of the three revenue concepts.2 . TR reaches maximum when MR = 0. The TR curve is inverse U-shaped as TR initially increases and then decreases with output. 1. if “average” is falling (rising). if we graph TR against output (i. that is.) 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.) TR (Rs. it rises initially and then falls. MR < AR. Moreover.2 respectively graph the TR curve. if output is measured on a continuous scale. and the AR and MR curves corresponding to Table 6. certain level of output it becomes negative. AR and MR under Monopoly Output Price (Rs. the TR curve). Initially it is positive and after a Table 6.2.) MR (Rs. 5. “marginal” is less (greater) than the “average”. AR and MR Curves corresponding to Table 6. Thus the shape of the TR curve facing a monopoly firm is quite different from that facing a competitive firm. This follows from the relationship between “average” and “marginal” discussed in Chapter 3. 3. (a) (b) Fig. 6. This is because MR is initially positive and then negative. it is always same as the demand curve facing the firm. Therefore. TR first increases with output and then it decreases. at all other levels of output.) AR (Rs. Panels (a) and (b) of fig. if we wish to graph the AR curve.
Therefore. This is indeed a very general condition of profit maximisation by a firm. They do. AR and MR Curves 6. the savings in cost will be greater than the revenues lost and hence profits will be higher. which will be more than the additional cost involved in increasing the output. where MR = MC.) Recall that for a competitive firm MR = P and thus the condition P = MC is a special case of the general condition MR = MC. these are respectively equal to additional revenue and additional cost. (A) .OTHER FORMS OF MARKET STRUCTURE 113 Fig. (a) The condition (A) is quite intuitive. a monopolist maximises profit by selecting the level of output at which MR = MC. by definition. however.2Profit-Maximising Rule A full analysis of a monopoly’s profit maximisation or producer’s equilibrium is beyond our scope here. But we can state its condition: MR = MC.2.3 Smooth TR.3 depicts a smooth hypothetical TR curve and the associated AR and MR curves. In monopoly. 6. (It was noted in Chapter 4 also. (b) Fig. MR will exceed MC. 6. Thus the firm will obtain more profits if it increases its output. On the other hand. as long as MR > MC. at a very large level of output. Shifts in the Demand Curve (AR) or in the MC curve do affect a monopolist’s output and price. Since. At very low level output. This does not mean however that demand and supply forces do not interact. 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. TR reaches its maximum when MR = 0. This means that. profit is maximum at the level of output. There is no question of the optimal level of monopoly output at different prices. As you can notice. 6.3 Monopoly Versus Perfect Competition These are the following general and important features of monopoly in comparison to perfect competition. 1. a marginal increase in output will fetch additional revenues. That is. Hence there is no supply curve as such under monopoly. MC will be very high and MR very low (possibly negative). the fir m decides output and price. if the firm reduces output.2.
2. . less is sold − and therefore less is produced − under monopoly than under perfect competition. Hence. we can then say that the monopolist produces less and charges a higher price. along a given demand curve. essentially. by virtue of a patent. that if they merge with each other − and thereby become a monopoly − they can reduce their costs. These two relations imply that P > MC. one firm may have excellent technical manpower but may not have good marketing skills. it follows that. which drives profits to zero in the long run. the resulting monopoly firm’s MC curve will be at a lower level and thus it will be a more efficient firm. by definition. it is quite possible – and likely – that over a long period the monopolist loses its monopoly power.4 MERITS OF MONOPOLY But before we rush to this conclusion we should note some good things about the monopoly too. by itself. in the first place. But the point is that as long as there is monopoly. 6. It means that a monopoly. while price is equal to marginal cost in perfect competition. They realise. 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. the patent eventually expires and other firms use the same technology and there is competition. In contrast. the monopoly price being higher than the competitive price. We already know that. This. in a sense. By merging.6 3. 6 The last point summarises what is “wrong” with a monopoly market structure. however. 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. It is the basis of negative sentiments against a monopolist. in monopoly. there is little analytical difference between short run and long run in terms of output and price determination. Suppose that initially there are two firms in an industry and both are somewhat inefficient. charges “too high a price” for its product. will induce the monopoly However. Now we come to the most important behavioural difference between monopoly and perfect competition. that is.114 INTRODUCTORY MICROECONOMICS 2. In perfect competition there is a major difference between short run and long run. Not only are cost curves different (because there are no fixed costs in the long run). P > MR and it selects an output level where MR = MC. there is no entry and exit. whereas the other may not have good technical manpower but possesses superior marketing knowledge. compared to perfect competition. 1. if the monopoly is present. For instance. the price exceeds marginal cost under monopoly. In summary. there is free entry and exit. for a monopoly. there is not much analytical difference between short run and long run. For example. Moreover.
(c) there is product differentiation. Loreal. Acquafresh. in which both competitive and monopoly elements are present. Colgate. (a) states that each firm is small relative to the market. each firm produces a brand or variety (of the same product) that is unique.. there are 7 brands of lipstick available in the Indian market: Avon. The objective of this legislation is to permit mergers.. Moreover.3 MONOPOLISTIC COMPETITION This is an interesting market structure. The varieties produced are very close substitutes of one another. the resulting monopoly will be in a position to exercise greater market power and charge the monopoly price. We already know that this is a bad thing. Babool. (a) There are a large number of sellers and buyers. acquisitions and business practices that have strong ef ficiency ef fects and prevent those. different from what any other firm produces. which is greater than when both firms were competing with each other. For example. which is less. there is a trade-off between efficiency and market power. Close-Up. Cibaca. Revlon and Tips & Toes. Many countries including India have the so-called anti-trust legislations to deal with this issue. On the other hand. i. If ef ficiency gains are suf ficiently strong.OTHER FORMS OF MARKET STRUCTURE 115 to charge a price. That is. This is a good thing about monopoly. Maybelline. Another major benefit from granting monopoly is that monopoly power and profits provide incentives for inventions and innovations. Elle.8 Features (a) and (b) are competitive features.g.e. (b) There is free entry and exit in the long run. . Hence. the MRTP Act of 1969 is the land-mark anti-trust legislation. soap and lipstick are prominent examples. Forhans. Pepsodent. In reality. 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. Neem. these activities are very risky propositions. There are many more brands of toothpaste. Anchor. Amar. then a monopoly serves the society better and hence is preferable. Often times they materialise from individual efforts and persistence.7 2. (b) implies that firms earn zero abnormal profits in the In India. 6. Lakme. Promise and Vicco Bajradanti. Its features are the following. and produce a quantity. e. which are meant to create or enhance market power accompanied by little efficiency gains. this is indeed the essence behind granting patents. Meswak. at the point of writing this book. 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. Products like toothpaste.
i. Unlike in monopoly. there is no need to engage in persuasive advertisement. (c) is a monopoly feature in the following way. there is only one firm producing a given brand. See Clip 6-3 for a brief description of oligopoly. Therefore. except for one qualitative difference. Analytically. there is one aspect of it. In perfect competition. the product is perfectly homogeneous and hence there is no scope to engage in persuasive advertisement. That is. since there are close substitutes available for any particular brand. where the letter “L” refers to the long run. information about health). Moreover. each firm has some monopoly power. There can be informative advertising (e. Realise that such selling costs do not benefit the consumers as a group: they only serve to move consumers one brand to another. which is different from both perfect competition and monopoly. in terms of decision-making. which exceeds marginal cost. No one else produces exactly the same brand. As said in the beginning of this chapter.. In this sense. In other words. there is free entry and exit. monopolistically competitive firms typically engage in advertising.g.e. In monopoly. it charges a price. However. This is persuasive advertisement and its purpose is to lure away consumers from other brands. since there is no competition. There is. . which implies that abnormal profit is driven to zero. all these are analogous to the case of monopoly.116 INTRODUCTORY MICROECONOMICS long run. 9 Although the features of monopolistic competition are a combination of perfect competition and monopoly. Together with the profit maximising condition MR = LMC we can then compactly write the long-run equilibrium conditions in monopolistic competition as MR = LMC. such costs are “wasteful” from the viewpoint of the society. namely. That is. But they involve resources. which can be potentially used for production. As we have already seen. compared to other brands. they incur advertising costs or what is also called selling costs. this is equivalent to P = LAC. however. 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. we leave out one important form of an imperfectly competitive market. Not all advertising costs are wasteful. a major difference between monopolistic competition and monopoly in the long run. Even though a firm is small and produces a brand that has many close substitutes. the demand curve facing a monopolistically competitive firm (unlike that facing a monopoly firm) is very elastic. where MR = MC. 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). oligopoly. yet it is a unique brand. P = LAC. which is useful for the consumers. implying that the AR curve must be quite flat.9 This closes our analytical discussion on market structure.
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.
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
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?
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?
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
) 0 10 20 30 40 50 60 70 6. firms. Section III 6. Output (units) 0 1 2 3 4 5 6 7 MR (Rs. AR and MR schedules. Derive its TR. Price (Rs.) — 14 10 7 5 0 –3 –5 .46 Quantity Demanded (units) 8 7 6 5 4 3 2 0 The MR schedule of a monopoly firm is given below.45 The demand schedule facing a monopoly is given below. under monopolistic competition.44 Explain how in the long run equilibrium with free entry and exit. Derive the TR and AR schedules. earn zero abnormal profits.120 INTRODUCTORY MICROECONOMICS 6.
48 What will be total quantity sold in the market and how many firms will operate in the long run competitive equilibrium? (b) Suppose that. 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. . the average cost curve shifts down such that the minimum average cost is equal to Rs. because of technological progress. Price (Rs.OTHER FORMS OF MARKET STRUCTURE 121 6.47 The technology is such that the long-run average cost is minimised at the firm output equal to 10 and the minimum longrun average cost is Rs.) 10 12 15 18 20 (a) Aggregate Quantity Demanded 1800 1440 1200 1000 760 6. 12 and it occurs at output level 8. 15. Suppose that the demand schedule for the product is given as follows.
U N I T-V FACTOR PRICE DETERMINATION .
Dissimilarities arise because the demanders and suppliers in a factor market are opposite of who they are in a product market. Income distribution. Instead of the economy’s central problem of “what. determine income distribution in an economy.2 Total Factor Demand. In factor markets. In general. consider the labour market. and if so. In other words we dealt with the central problem of “what” facing an economy. The price of labour service is the wage rate. in turn.e. For example. we examined the product markets: which good or service will be produced. firms are demanders and households are suppliers. The issues are different also.. how much and what its price will be. We will learn how the wages to different types of labour are determined in a market economy. machinery and equipment). e. Factor Supply and Equilibrium 7. There are similarities and dissimilarities between product and factor markets.3 Trade Unions In Chapter 2 to Chapter 6.FACTOR PRICE DETERMINATION 123 CHAPTER 7 FACTOR PRICE DETERMINATION • • • 7.1 Factor Demand 7. Households are demanders and firms are suppliers in product markets. different types of labour or skill. In this chapter we examine factor or input markets. determines differences . earnings to different individuals in the form of wage income or income from land etc.g.” the factor market analysis sheds light on the “for whom” problem. capital (i. land etc.
rents warehouse space for storage etc. given factor prices. 20 × 7 = Rs.1 FACTOR DEMAND 7. The former refers to different levels of total output at different levels of employment . recall in particular the definitions of Total Physical Product (TPP) and the Marginal Physical Product (MPP). then we can measure labour as the number of workers hired. we are not differentiating between different types of workers at the moment. hiring more of factors will generate more output. the total cost of labour is Rs. This is how the factor market implications are linked to central problem of “for whom. which will generate more revenues (as long as the marginal revenue is positive). The equality between demand and supply of a factor determines the respective factor price. and so on. If the firm hires 4 hours of labour. 20 × 4 = Rs. 80. For instance. 7. From Chapter 3. The question is. 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. how many labour hours (denoted by L) a firm should employ? The total cost of fixed factors is fixed by definition.. 140. 7. a firm faces different prices for different factors.” The similarity between factor and product markets lies in that there is a demand side and there is a supply side of a factor. What we need to do then is to combine what we have already learnt.) In other words.1 A Firm’s Problem At a given point of time. Warehouse facility may be available at the rate of Rs. the total cost of labour or the total wage bill is Rs. i. except one. think of a transport and storage company.1. hiring more factors will cost more.124 INTRODUCTORY MICROECONOMICS in the purchasing power over goods and services among individuals or households.e.1. 50 per day per cubic metre of space. 15.2 One Variable Factor To begin with. how much of different factors a profit-maximising firm should hire? On one hand. suppose that the employment levels of all factors. there is only one variable input and the rest are fixed. Realise that we have already studied (a) in Chapter 3. We also have analysed (b) − for a competitive firm in Chapter 4 and for a monopoly firm in Chapter 6. (If all workers are supposed to work a given number of hours per day. Suppose that the wage rate is Rs. The total cost of the variable factor (labour in our example) is easy to compute. The question is. If 7 hours of labour are hired. On the other hand. The prevailing hourly wage rate may be Rs. 20 per hour. For simplicity. measured in hours of work. Let this variable factor be called labour. It employs workers. are fixed. let us assume throughout this chapter that the firm under consideration is a perfectly competitive firm.
3 in Chapter 3. Consider the TPP schedule and the MPP schedule. This is indeed same as total revenue. we need to know the product price. In particular. defined as P × MPP. which will fetch extra revenues equal to the value of this extra output. we also know the shapes of the TPP and MPP curves. the inverse U-shape of the MPP curve follows from the law of diminishing returns. We need two more concepts before we are able to answer in principle the question of how much of a factor a profit-maximising competitive firm will employ. The 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.FACTOR PRICE DETERMINATION 125 of a factor. 2. Table 7.TPP (Rs.1 gives the TPP schedule. The first is the Total Value Product (TVP). as given in Tables 3. where P is the product price. TVP and VMP Schedules MPP — 10 12 11 10 8 5 0 –8 –12 Product Price = Rs.MPP (Rs. The Table 7. when the employment of other factors is unchanged. the MPP schedule as well as the associated TVP and VMP schedules. TPP. From Chapter 3. MPP. VMP is equal to the increase in TVP or total revenues per unit increase in the employment of the factor. 2 TVP = P. Equivalently.1 Labour Hours (L) 0 1 2 3 4 5 6 7 8 9 second one is the Value of the Marginal Product (VMP). In order to calculate the TVP and the VMP. It is because an extra unit employed of a factor generates extra output equal to MPP.) 0 20 44 66 86 102 112 112 96 72 VMP = P. Suppose that P = Rs.) — 20 24 22 20 16 10 0 –16 – 24 TPP 0 10 22 33 43 51 56 56 48 36 .2 and 3. defined as P × TPP.
i. will be inverse Ushaped. smooth VMP curve is shown in fig.e. the TVP is equal to the area 0ABL1. Fig. a small firm − hires in the labour market. This is equal to the sum of VMPs at L = 1 (20). TVP of a particular level of factor employment is the sum of VMPs up to that level of employment. if we draw a smooth VMP curve. which governs the nature of the MPP schedule. B. 7. It is proportional to the MPP schedule as it is obtained by multiplying the MPP schedule by price. It initially increases with factor employment and then diminishes. the total revenue). at L = 3.2 Factor Price Line . also determines the nature of the VMP schedule. Property B implies that. for instance. Now we discuss how it affects its costs. Fig. the firm hires L1 labour hours. just as the MPP curve. This is illustrated in fig.e. 7. 7. TVP = 66. the graphical representation of a VMP schedule. which is constant. For instance. W. For instance.1(a). 7. Property A implies that the VMP curve. 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. 7. It is a horizontal line since the wage rate is unaffected by how many labour hours our (a) (b) Fig. A general. at L =2 (24) and at L = 3 (22). 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. Suppose that the factor L costs W per unit. at L = L1. its total wage bill is the area 0WCL1.1 The VMP Curve competitive firm − by definition.1(b).. This implies that the law of diminishing returns. A. If. the area under it will be equal to the TVP (i.2 draws the Factor Price Line or the “wage line” in this case. the hourly wage rate is Rs.126 INTRODUCTORY MICROECONOMICS Particularly relevant for us will be the VMP schedule and its properties.
it is equal to W0 AFD. Indeed the two conditions are two sides of the same coin. . Similarly.3. gross profit is maximised where profit is maximised and vice versa. TVP or total revenue is equal to the area 0ACL0. The law of diminishing returns is the key. which combines figs. any deviation from the principle (A) will only generate less profit.1(b) and 7. profit = gross profit – fixed cost. if the firm hires one extra unit of the factor. where the factor price line intersects the VMP curve. Thus profit will be less. it should hire L0 labour hours.1 Now consider any employment level less (such as LA) or more (such as LB) than L0. This implies less profit than before. We can compute that the profit is less than W0 AC. For instance. at L = LA. At L = LB. The total factor cost is equal to the area 1 0W0 CL0. 7. This proves that profit is maximised at L = L0. it is equal to W0 AC – CEG. The adjective “gross” is attached. Starting from where the VMP of a factor is equal to its price and the MPP is diminishing.3 Factor Employment Decision This condition is perfectly parallel to the profit-maximising condition for a competitive firm. since the fixed costs are given. which is the difference between TVP and total factor cost. the general principle of hiring a factor (or profitmaximisation with respect to a particular factor) is (A) VMP of a Factor = Its Price. The rationale behind condition (A) is also parallel to that behind P = MC.e. The answer is that the firm should hire up to that level. the VMP will be higher than the factor price. 7. the VMP will be less than the factor price. which is equal to W0 AC – CDF. if the firm hires one less unit than where VMP is equal to the factor price. At L = L0 . In other words. By definition. that is P = MC. since fixed costs are not deducted. 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). Let the factor price facing the firm (wage rate) be W0. Fig. In summary. However. This proves why profit is maximised when condition (A) is met.FACTOR PRICE DETERMINATION 127 We are now ready to derive the principle that governs how many labour hours a profit-maximising firm should hire. under diminishing returns. i. Turn to fig. is equal to the area W0 AC. 7.2. 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). Thus the gross profit. As a result.
derived from product demand. in a sense.1. factor demand is said to be a derived demand. P.4. This is parallel to the supply curve of a firm being same as the upward sloping portion of the marginal cost curve. the factor demand curve shifts to the right (or up). who. the product is sold in 2 Fig. The general point here is that factor demand is.128 INTRODUCTORY MICROECONOMICS Factor Demand Curve Note from the preceding discussion that a firm always chooses a point on the VMP curve.4 Product Price Increase and Factor Demand India and abroad. consider the industry of a particular handicraft.3 Factor Demand Curve Shifts Since the factor demand curve is a part of the VMP curve. This is illustrated in fig. 7. Suppose that in an international exhibition this handicraft attracts a lot of attention. increases the VMP at any given level of factor employment. In general then. with the help of raw materials and equipment. 7. On the demand side. From this result. We consider the following sources of change. This means that the downward portion of the VMP curve is the firm’s demand curve for the factor. This is why. never at a point where diminishing returns do not hold. From the demand-supply analysis in Chapter 5 we know the effect: the price of this handicraft increases.2 It also means that a firm’s demand curve for a factor is downward sloping. . there are artisans. Next we examine the determinants or the sources of shift of the factor demand curve. anything that shifts the VMP curve shifts the factor demand curve. Hence an increase in the product price. Consequently there is an increase in demand for this handicraft. As a consequence. 7. we can say that an increase (a decrease) in the product price shifts the factor demand curve to the right (left). A Change in Product Price By definition. and moreover.MPP. Now consider the (factor) market for artisans. VMP = P. The increase in the price of the handicraft will shift their VMP curve and hence the demand curve for artisans to the right. On the supply side. make the handicraft. Many people and organisations around the world come to know about it and they like it. we can see a link between product and factor markets. For instance.
their respective prices are WX and WY. firms employ many.g. 7. Otherwise. Fig. . and their respective marginal products are MPPX and MPPY. e. different types of labour. there are two factors.. If it is 3 Another possible source of a shift in the factor demand curve. then the demand curve for that factor shifts to the right.1. the whole world economy has experienced technological progress that has increased the MPP of skilled labour. then its demand curve shifts to the left. VMPY = P. Fig. 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). Whether it has increased the MPP of unskilled labour is not clear. If.5 Technological Change and Factor Demand Technological Change A technological change can alter the MPP of a factor and thereby its demand curve. For example.MPPX = WX . 7.FACTOR PRICE DETERMINATION 129 (a) Technological Change increasing the MPP of a Factor such that the MPP of a factor increases. 7. if the MPP of a factor decreases due to a technological change. raw materials. In reality. in recent two/three decades. it is widely believed by economists that. the profit-maximising principles are: (A') VMPX = P. for example. is the change in the employment of other factors. even when the product price is unchanged.3 Marginal Productivity Theory of Distribution So far we have assumed that the firm employs only one variable factor of production. (b) Technological Change lowering the MPP of a Factor Fig.MPPY = WY. power.3 7. which we have not discussed and which is something to be done in a higher course in microeconomics.5(a) shows this effect. various kinds of machines.5(b) illustrates this. land etc.
WX is the skilledlabour wage and WY is the unskilledlabour wage rate. the marginal productivity theory does hold. Both work in the same sector. So. 4 In principle. MPPY Hence. There are many fir ms in a per fectly competitive industry. and. each factor ear ns the value of its marginal physical product. with appropriate interpretation.2 TOTAL FACTOR DEMAND. let P be the price of the good produced in that sector. If the salaries of school teachers increase. some factors are used in many industries and in that case.MPPX P . because the (marginal) productivity of skilled workers is greater than that of unskilled workers. the total demand curve for a factor is the horizontal summation of individual (firm) demand curves for that factor in various industries combined. 5 We now turn to the supply side. Consider. Note that even when there is more than one variable factor. we get the total industry demand curve for that factor. We have derived a single firm’s demand for a factor. for example. if MPPX > MPPY. from Chapter 1. that skilled workers normally earn more than unskilled workers. when we do take into account the supply side. 7. 7. This theory implies. then WX >WY . It is called the marginal productivity theory of distribution.4 However. for example. To simplify the discussion. 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. skilled labour earns more than unskilled labour. which concerns who earns how much. That is. In Fig. factor Y is unskilled labour.MPPY MPPX . suppose that factor X is skilled labour. the total demand for a factor is shown as the line DD. However. that is. How DD is derived is parallel to how the product market demand curve is derived from individual demand curves. FACTOR SUPPLY AND EQUILIBRIUM WX WY P . the central problem of “for whom” facing an economy. In order to see this and analyse factor market equilibrium in general. let us return to the one-factor case.6(a) and (b). To see this more exactly. if we sum up the demand for a factor across various firms. the definition of MPP remains valid. Then from (A´). factor prices should be determined by forces of demand and supply both. Recall. This complication arises due to a change in the price of the commodity when all firms increase or decrease their outputs together. the price of the commodity is implicitly kept constant during this summing up. not just by demand forces that we have emphasised so far.130 INTRODUCTORY MICROECONOMICS That is. . teaching service as a factor of production (in producing education). The conditions (A') imply a theory of this. profit is maximised when the VMP of each factor is equal to its price.
In the short run the land supply is given. Supply and Market Equilibrium of a Particular Skill Thus the land market equilibrium is similar to that of a particular skill. The intersection of demand and supply curves defines equilibrium in the factor market − similar to what happens in a product market. take years. In the long run it is likely to change. building floors etc. capital etc. The equilibrium wage is denoted by W0. Besides different types of labour. . true in the long run. because teachers’ education. 6 7 (a) Short Run (b) Long Run Fig. The short run and long run factor supply curves. The earning of land is the rent per unit of space. training and certification etc.6 respectively. It is different from price of land as an asset. and N0 denotes the equilibrium amount of the particular skilled labour that is hired. a firm hires land.7 In the present context this is the “price” of land in terms of its service as a factor of production. In both panels. 7. There are exceptions. however. denoted by SS. the supply of school teachers in a particular region will be given. of a particular skill are shown in panel (a) and panel (b) of fig. This is true for almost any type of (relatively high) skill. Here land does not just mean a piece of land per se but includes room.6 Hence the long-run supply curve of land is upward sloping also. 7. In the short run. like over a few months or over a year.FACTOR PRICE DETERMINATION 131 teaching as a career. more land or space will be supplied by landowners. These are examples of non-human factors of production. but land supply to the entire economy is given.6 applies except that “rent” substitutes the “wage rate” and “land” substitutes “labour.” A point to note here is that. E denotes the market equilibrium point. the supply of land to a particular industry is upward sloping (in the long run). Fig. Consider for instance the supply of land.6 Demand. Hence the supply curve of this factor service is upward sloping. Higher the rent. This is. if we interpret land narrowly in terms of area on ground. Countries like Japan and Hong Kong have claimed land from sea. 7.
there is also an important example where a factor price is not determined by the market. In the factor market. A. 7. 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). For instance. if there is an increase in the demand for a commodity.g. Sometimes they organise strikes and boycott work for days and weeks.6 applies to the market for a particular type of capital. The .3 TRADE UNIONS The demand-supply analysis above refers to how the price/market mechanism works in factor markets. What effect does this “wage-fixing” by trade unions have on the labour market? Turn to fig.g. You might have heard of workers’ organisation in various sectors of the economy called trade unions or labour unions. the wage of this skill (e. machinery etc. The term capital in economics means different things in different contexts. the factor reward is equal to the value of its marginal physical product. from the demand side. Very often they also try to bargain for higher wages than the employers are willing to offer. A technological change that improves the MPP of a factor will enhance its reward. There are two general implications of our factor demand-supply analysis. the production of which requires a specific skill (e. By now this conclusion must be something very evident to you. fig. 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. at the equilibrium point. Whichever factor is under consideration. 7. B.e. whereas the total land space is non-reproducible. it can be increased continuously over time. Here it means plants. which is higher than what the equilibrium wage rate would have been in the labour market. of computer engineers) will increase. It is dissimilar to land in that the total capital stock in an economy is “reproducible”. We say that capital earns rental. then the hourly or daily rate you charge is an example of capital earning rental. 7. computer skills). This is the supply curve of labour. It can be applied to various sources of shifts and their effect on factor price. where Ls denote the total number of workers. In any event. It is similar to land in that it is non-human. equipment. These unions voice grievances of workers in a collective way.132 INTRODUCTORY MICROECONOMICS Capital is also a factor of production. 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. Sometimes they succeed in negotiating a wage rate. If you own an Ambassador car and use it for taxi business. i.7. This is parallel to our demandsupply analysis for commodities in Chapter 5.
If there were no trade unions. 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. which is indicated at the point D1 on the labour demand curve. W0 would have been market wage. The total factor cost or payment to a factor is the area under the factor price line. 7.7 Trade Unions and Unemployment Thus. L 1 L s measures the number of workers who are unemployed. the VMP curve of a factor is generally inverse U-shaped. In the diagram. the firms will demand less labour. unemployment sometimes may be caused by the presence of trade unions. As a result. TVP of a factor is equal to the area under its VMP curve. Factor price is determined by forces of demand and supply of a factor. which is higher than W0.FACTOR PRICE DETERMINATION 133 demand curve for labour is denoted by LD. or equivalently. Now suppose that the trade union fixes the wage at W1. What we see now is that there is unemployment of labour. For a competitive firm. The demand curve for a factor is essentially the downward sloping portion of its VMP curve.” . This is because of the law of diminishing returns. In this sense. For a competitive firm. For a competitive firm. SUMMARY l l l l l l l l A factor service is demanded by firms and supplied by households. at the point L1 on the horizontal axis. Fig. profit maximisation occurs when each factor is paid its VMP.
is different from land in the sense that.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.10 7.2 7.12 7. Capital.9 7. unemployment results in the labour market. The total demand curve for a factor is the horizontal summation of individual (firm) demand curves for that factor. unlike land. it is typically reproducible. while an increase in the supply of a factor tends to lower its price. but it may be vertical in the short run.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. at a higher wage rate.5 7. When a labour union fixes a wage above the market-clearing wage.7 7. as a factor of production. An increase in the demand for a factor tends to increase its price.1 7.4 7. What is the relationship between the wage rate that a labour union typically fixes and the equilibrium wage rate? .6 7.11 7. while the supply of labour by workers may increase or remain unchanged. Skilled labour is paid more than unskilled labour because the marginal product of former is higher than that of the latter.8 7. EXERCISES Section I 7. The supply curve of a factor is upward sloping in the long run. Marginal productivity theory implies that different factors are paid differently because of differences in their VMPs. firms employ less labour.3 7. It is because.
17 7. 40. The price of the factor is Rs. which were used for renting. 70 per unit. MPP = 5.20 7. at this level of employment. At some level of employment. The price of the product is Rs. How many units of that factor are being employed? Suppose that the product price is Rs. What is the MPP at L = 5? The product price is Rs. Employment of a Factor 0 1 2 3 4 5 6 7 8 7. 12.19 7. 3.22 The total payment to a factor is Rs.FACTOR PRICE DETERMINATION 135 Section II 7.21 7.18 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.16 TPP (units) 0 8 20 32 42 50 56 60 62 7.15 7. That at L = 5 is 65 units. Show that. Should the firm increase or decrease employment in order to increase its profits? Explain why a factor demand is called “derived demand. profit is not being maximised. 5. All other things .14 The TVP at the employment level L = 4 is 50 units. 10 and a factor is paid Rs.000. The law of diminishing returns holds.” What does the marginal productivity theory of distribution say about the earnings of different factors? Explain why skilled workers earn more than unskilled workers. The TPP schedule of a factor is given in the following table. Derive its VMP schedule.
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.25 Explain how profit is maximised when the VMP of a factor is equal to its price.23 remaining unchanged. the VMP curve for an input is considered its demand curve. Explain why. How will it affect the wage of unskilled labour? Section III 7.136 INTRODUCTORY MICROECONOMICS 7. under perfect competition. . How will it affect the wage of skilled labour? Further suppose that the technology advance lowers the MPP of unskilled labour.24 7.
we learn a very important concept in economics. our objective is to learn some fundamentals of international trade. which is an example of trade in services. in general. INTERNATIONAL TRADE AND FACTOR MOBILITY 8. As an example of trade in goods. are much more interdependent today than they were 30 or 40 years ago. the countries themselves. called comparative advantage.COMPARATIVE ADVANTAGE. and. i. because countries. in the sense that each party has something to offer to the other. INTERNATIONAL TRADE AND FACTOR MOBILITY 137 CHAPTER 8 COMPARATIVE ADVANTAGE. Through this concept. This is very important. Many foreign banks today offer banking services in India. trade/exchange with each other in goods and services.2 Factor Endowment Theory of International Trade 8. it is not true that. On the contrary.3 Factor Mobility • • • In previous chapters we studied how producers and households interact with each other in product and factor markets. if one country gains from it. we will understand that promoting international trade is not a bad thing. some other country has to lose. We can think of such interaction as “trade” between producers and households. India exports tea to the rest of the world and imports petrol. consumers and producers across countries. In the process. This is called international trade.e.1 Ricardo's Theory of Comparative Advantage and Benefit from Trade 8. we will . Not only producers and consumers within a country trade with each other. In this chapter..
both are better off by trading with each other. in comparison to producing all goods it can produce and not trading. We also consider another source (basis) of comparative advantage.000 per hour. Although Ricardo wrote about it almost two hundred years ago (in the early 19th century). A country. Ricardo’s theory of comparative advantage and trade is based on differences in technology across countries.1) and gains from trade can be understood through this example. Put differently. 5. whereas you can hire an excellent cook at the rate of Rs. This is in the sense that if you sing you get Rs. differences in factor supplies across countries. Now think about this example in a different light. cooking) and. i. What applies for an individual in the above example also applies to a country. The idea behind comparative advantage (to be defined in Section 8. 300 per hour. That is. its relevance is felt even today. I have something which you want but cannot obtain that easily. One option for you will be to pursue a singing career and still cook for yourself – be “selfsufficient”. you are capable of doing both and you actually choose to do both. In simpler language. and you have something that I want but cannot get that easily. The next two sections study these alternative sources of comparative advantage. The latter option is like importing the service that you do not have comparative advantage in (that is.. This principle was first demonstrated formally by a famous English economist. it implies that countries can trade and benefit by exploiting their differences. named David Ricardo. . you save Rs. namely. specialising and exporting the service you have comparative advantage in (that is. 300 per hour. In what follows. Which option will you prefer? Surely. It is the simplest and yet a very elegant exposition of how international trade can be beneficial to a country. This is the idea behind comparative advantage.138 INTRODUCTORY MICROECONOMICS learn that trading with each other is. it means that you and I are different. singing). Suppose that you are a very good pop singer and a very good cook. by and large. we first discuss Ricardo’s theory of comparative advantage. if you cook. the latter. so-to-speak. 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. a mutually beneficial activity. But you are much more productive as a singer than as a cook.e. Consider now the alternative option of hiring a cook and engaging yourself full time in singing. 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. As we will see.
COMPARATIVE ADVANTAGE, INTERNATIONAL TRADE
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
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.
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
COMPARATIVE ADVANTAGE, INTERNATIONAL TRADE
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
Why? Suppose it exceeds 4. but because they help us to see the effect of trade very clearly. Also.142 INTRODUCTORY MICROECONOMICS other good that one gets in exchange for one unit of the good in question. it means that the world relative price of football will be in between 2 and 4 cricket bats.) The above assumptions imply that the exchange ratios or the relative price of a good will be the same in the two countries. This is intuitive. Range of World Terms of Trade The next question is: what will be the equilibrium world terms of trade? Terms of trade. In this example. In Australia for example. the exchange ratios will be the same. assume that there is no transport cost of moving goods between the two countries. In equilibrium. i. 8. You can similarly calculate the exchange ratio in Australia: 4 cricket bats for 1 football. the relative price of football is 4 cricket bats and the marginal opportunity cost of football is also 4 cricket bats. 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). it is an exchange ratio between goods. and cricket bats are relatively cheaper in Australia. let there be “free” trade. every one in both countries will buy the product from the former country and this will push its price up. 3. no restrictions like trade taxes or any limits on how much a country can export or import etc. find its range: it will lie in between the domestic exchange ratios. But we do not have any information on the demand side. It is because. (We make these strong assumptions. we cannot determine the world terms of trade exactly. It cannot exceed 4 or fall short 2. We then have the exchange ratio in India in the no-trade situation equal to 2 cricket bats for 1 football. The stage is ready now to understand the effect of international trade. Also notice from the exchange ratios that football is relatively cheaper in India. which has comparative advantage in producing football. Further. We can call these the domestic exchange ratios. say . if a good is cheaper in one country than in the other. which has comparative advantage in producing cricket bats. We can. however.4 Effect of International Trade Let India and Australia now open up trade. 4.. We can call this the world exchange ratio or what is called the world terms of 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. not because they are critical for our argument.e. in general. Hence. Put differently.1. The supply side of an economy is represented by the PPC of a country.
We can then summarise that in the Ricardian world economy. That is. What are the consumption possibilities facing the two countries and how do they benefit from trade? But before we address this question.2.e. From the viewpoint of India.COMPARATIVE ADVANTAGE. which graphs the same PPCs as in fig. we should know what we mean by exports and imports. This will mean that there are abnormal profits in the football sector. Mark that football is the good. whereas imports of a commodity are equal to its consumption minus its production. . Australia specialises in cricket bats. you can group them into the “home” country and “the rest of the world” and the same argument holds. which is greater than its the marginal opportunity cost (equal to 2 cricket bats). INTERNATIONAL TRADE AND FACTOR MOBILITY 143 1 football for 5 cricket bats. the two countries comprise the world economy. in both countries. i. Then. Specialisation occurs as the world terms of trade are different from the domestic exchange ratio. This is how international trade affects production and resource allocation in an economy.) You can similarly argue that if the world terms of trade are 1 football for something less than 2 cricket bats. produces football only. a football fetches more than it fetches in the no-trade situation and thus both would like to export football. a trading country specialises in the good. As an example. Assume that the world terms of trade lie strictly in between the two domestic exchange ratios. 8. suppose that they are equal to 1 football for 3 cricket bats. then its production exceeds (falls short of) its consumption in the country. in which it has comparative advantage. the relative price of football is 3 cricket bats. India’s and Australia’s production points in free trade are shown at points D and H respectively. In other words. Hence resources (labour) will move out of the cricket bat sector to the football sector. India “specialises” in football. in the production of which it has comparative advantage. 8. This is shown in fig. Specialisation Now think about how much of each good will be produced in the two countries. if a good is exported (imported). Consumption Possibilities Now we come to the last stage of our discussion. as long as the world terms of trade differ from the domestic exchange ratio. This proves that the equilibrium world terms of trade will lie between the domestic exchange ratios. since there is no third country they can both export to: by definition. This process will continue until there is no production of cricket bats in India.1 (shown by the dashed lines). in the production of which India has comparative advantage. But this is not possible. Exports of a commodity are equal to its production minus its consumption. By similar argument. both countries would want to import football and that is not possible. (When there are more than two countries.
2 The concept of slope of a straight line is explained in Appendix 2. you can see that for every possible consumption point in the no-trade situation.g. the consumption possibility curve for India at the world terms of trade. since India produces at D. the relative price of football in the world market. free trade must be preferred to no trade. Note that. 8. By similar argument. 8. or 2 footballs in exchange for 6 cricket bats (all imported) and so on. irrespective of which consumption points on DE' and G'H are chosen. A. one consumption possibility for her is the point D itself. it can export one football in exchange for 3 cricket bats (all imported). These possibilities give rise to the heavy line DE'. e. which only offered the consumption possibilities along the PPC that lies to the left of or “inside” the line DE'. India exports footballs and Australia exports cricket bats. except the corner points on the PPC. But there are other possibilities. The line G'H lies outside Australia’s PPC. equal to 1 football for 3 cricket bats. Australia’s consumption possibility curve is now the heavy line G'H. Hence. . there is at least one point on DE'. whose slope is also equal to 3. For instance.2. That is. This situation is surely a better proposition for India than no trade. Alternatively. Thus Australia also benefits from free trade.144 INTRODUCTORY MICROECONOMICS (a) India Fig. whose slope is 3. equal to the relative price of football in the world market. which guarantees more consumption of each good.. 2 Put differently. is the heavy line DE'.2 (b) Australia Free International Trade in the Ricardian Economy In fig.
It is not that the technology cannot differ between countries. no country will have comparative advantage in producing any good and there will be no reason to trade. The lesson to be learnt from the Ricardian theory is that a country benefits from international trade by specialising and exporting the products that it has comparative advantage in. Otherwise. and is called the Heckscher-Ohlin theory. . 8. just like labour endowment in the Ricardian theory. technology differences are not only basis for comparative advantage and trade. 8. Likewise. Eli Heckscher and Bertil Ohlin. LN/KN is the relative endowment of labour in India. 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. we say that It was formulated originally by two Swedish economists. These are absolute factor endowments. They are required in producing each of these two goods.2. Having defined relative endowment. The theory 3 4 that brings out this point is called the factor endowment theory. For example. The ratio of absolute endowments is called the relative factor endowment. Even if international trade is opened between the two countries.1 Factor Endowment Difference Let LN and KN denote the endowments of labour and capital in India. We can call these factor endowments.3 View the world as having two countries once again. Suppose that the supply of each factor in each country is given. This is a very general principle of international trade. nothing will change in any country. suppose that there are two. In our example. if the ratio of labour coefficients is the same between the two countries. let L A and KA denote the endowments of labour and capital in America. say. Differences in relative factor endowment (to be defined in a moment) form another major basis for comparative advantage. This is true even when a country is more efficient in producing all goods in an absolute sense. They produce two goods: Chairs (C) and Medicine (M). There are constant returns to scale. we can always compare it between countries. However. then the domestic exchange ratios will be the same. Furthermore.4 All markets are perfectly competitive. it is the difference in technology that forms the basis of comparative advantage and mutually beneficial trade. Instead of one factor of production. India (N) and America (A).2 FACTOR ENDOWMENT THEORY OF INTERNATIONAL TRADE In the Ricardian theory.COMPARATIVE ADVANTAGE. INTERNATIONAL TRADE AND FACTOR MOBILITY 145 each country exports the good it has comparative advantage in. labour and capital. But the idea here is to suppress such difference and focus on difference in factor endowments.
relatively speaking. India is the relatively lowwage country and America is the relatively high-wage country. Let us invoke a result from that chapter which states that. and thus L N/K N>L A/K A. 1. How? Our analysis of factor price determination in Chapter 7 comes into play. But. 900 respectively. since it is reasonable to suppose that India is a relatively labour-abundant country. But it can say 5 something about relative factor price difference. 200 per day in America. Suppose that. Thus.2. the two absolute factor rewards are less in India. our relative factor ranking (A) implies this. in America. compared to America. 200 and capital earn rental equal to Rs.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. 8. because the ranking (A) does not say anything about absolute endowment levels. let LN = 1. Then LN/KN = 3. KN = 500. Indeed. since India (respectively America) is relatively labour – (respectively capital)– abundant. can we say anything about absolute factor price differences between India and America? The answer is no.000 and KA = 1000.2. the wage/rental ratio in India will be less than that in America. labour earns wage equal to Rs.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. if labour earns wage equal to Rs. 8. 50 per day in India and Rs. it implies that. In this case. we say that there is an absolute wage difference and the wage rate is less in India than in America. let the wage rate and the rental to capital be Rs.5 KA Let us assume this. if ( A) LN KN LA . In India. 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. the lower is its reward. It is 1/5 there and 1/9 in India. we say that relative reward (price) of labour is greater in America and the relative reward of capital is greater in India. For instance. 100 and Rs. where relative factor price is defined as the ratio of factor rewards. Given our ranking of the relative endowment in (A). there can be an absolute difference in the rental rate of capital between the two countries. In other words. the wage/rental ratio is greater in America.000. 500. greater the supply of a factor. . LA=2. LA/KA = 2.146 INTRODUCTORY MICROECONOMICS India is the relatively labour-abundant country and America is the relatively capital-abundant country. In general. Similarly. In the present context.
This is the gist of the factor endowment theory. the factor endowment theory has been merely sketched. country (America) will export the relatively capitalintensive good (medicine). low wage/rental ratio. The relatively capital-abundant. This is how the relative factor endowment difference and the relative factor price difference are linked to international trade. . in free trade. we can say that the relatively labour-abundant.e. in an economy. We can state this in terms of comparative advantage.compared to no trade. low wage/rental ratio. 2. country (India) will have comparative advantage in producing the relatively labour-intensive good. capital-abundant country. a country will produce more and export the product. labour abundant country. high wage/rental ratio. we learnt that the demand for a factor is called a derived demand. In Chapter 7. We next link comparative advantage to international trade: i. and. In contrast. 1. country (India) will export the relatively labour- intensive good (chair) and the relatively capital-abundant. 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. You can reflect back to see that the aforementioned result is quite reasonable. with lower cost) in the low wage/rental ratio country and in the high wage/ rental ratio country. INTERNATIONAL TRADE AND FACTOR MOBILITY 147 two countries. factor and product markets are very much interrelated. Remember that the production technology of chairs (C) is labour-intensive and that of medicines (M) is capital-intensive. Three remarks are in order.. Thus. Joining the two links now. The relatively labour-abundant. in which it has comparative advantage. This is because changes in product markets affect the demand for a factor.e.2. a general and an important point to be learnt is that. high wage/rental ratio country (America) will have comparative advantage in producing the relatively capitalintensive good.COMPARATIVE ADVANTAGE. 8. Unlike the material in previous chapters and our discussion of the Ricardian theory.4 International Trade Thus far we have linked relative factor endowment difference and relative factor price difference to comparative advantage. A specialised course in international economics will deal with this theory in more detail. the factor endowment theory illustrates how factor market differences influence the product market − the pattern of flow of goods between countries. the capitalintensive good (M) will be produced relatively more efficiently in the relatively high-wage. Ask yourself which good will be produced more efficiently (i. The answer is that the labour-intensive good C will be produced relatively more efficiently in the relatively low-wage.
India. a factor moves from the low-reward region to a high-reward region. Skilled workers move typically from countries like India and China to Europe and America. 8. That is. We can think of this issue in terms of demand and supply of a factor. the relatively capitalabundant country exports relatively capital-intensive goods. construction works are more prevalent in urban than in rural areas. there is an absolute factor price difference. We can look at this conclusion in a different light. . studied in Chapter 7. compared to rural areas. the absolute factor price difference (already defined) plays a role. Why is this so? Because. However. in urban areas than in rural areas. These are not the only instances of mobility. This again shows how interrelated goods and factor markets are. Put differently. In our example. both husband and wife work outside the home. America exporting relatively capital-intensive goods means that America is exporting capital services. Recall the central prediction of the factor endowment theory. not the underlying cause.148 INTRODUCTORY MICROECONOMICS 3. which explain the rural-urban difference in daily wage. There are thousands of workers from India who are working in middle-east countries like Kuwait and Yemen. although they are not (in our analysis). there are more nucleus families. In many urban households. First. cooking etc. In our country daily labour moves typically from villages to towns. Unskilled labour moves from Mexico to America. as opposed to joint families. Daily labour earns more in an urban area on an average than in a rural area on an average. international trade in goods can be seen as international trade in factor services. Given such a difference. India exporting relatively labour-intensive goods can be thought of as India exporting the “services” of labour. exports relatively labour-intensive goods and America. Indeed there are differences in both demand and supply sides. factors do move between regions and countries. Likewise. We now ask why factors move the way they do? Here. we have already noticed that in India daily labour moves from rural to urban areas. the absolute factor price difference or in this case the ruralurban wage differential. Hence there is a greater demand for household services like cleaning. Both these factors imply higher demand for daily labour in urban areas. unlike in the factor endowment theory. is just an immediate cause of factor/labour migration. As an example. Also. This induces it to move from rural to urban areas.3 FACTOR MOBILITY The very last point made brings us to the very last topic to be analysed in this book. This chapter − and the book − ends with an investigation of why a ruralurban wage differential exists. the relatively labour-abundant country. it is as if factors are moving internationally.
capital. WR. SSB. developing countries. INTERNATIONAL TRADE AND FACTOR MOBILITY 149 Second. . WB is greater than the rural wage.COMPARATIVE ADVANTAGE. The urban labour market equilibrium is shown at the point EB where DDB and SSB intersect. DDB. Skilled workers want to move out of countries like India and China to the U. Likewise. In the Ricardian theory. ceteris paribus. so that families of many daily workers prefer to live in rural areas.S. Once we establish that there is an absolute difference in wages. and Europe in order to earn higher wage for their skill. There are two demand curves. it is easy to predict that labour wants to move from a low-wage region to a high-wage region. the supply of daily labour in towns is less than in villages. the labour market equilibrium in the rural area occurs at the point ER where the curves DDR and SSR intersect. 8. Both these factors together imply that the urban wage must be higher. The one to the left. marks that in the rural area. Similarly. differences in technology form the basis of comparative advantage. As we can see clearly. marks the supply curve in the urban area and the one to the right. There are also two supply curves. We can see this in terms of fig. We should carefully note however that absolute factor price difference is only an immediate cause − or an indicator − of factor movement.3 Urban and Rural Wage for Daily Labour We note that this is true not just for unskilled labour but also for skilled labour. the urban wage. The one to the right. the urban cost of living is higher than the rural cost of living. high-rental. SUMMARY l l l The principle of comparative advantage implies that countries can benefit from trade by exploiting their differences. which earns less rental in capital-abundant developed countries. Average physical product a factor is the inverse of its coefficient. SSR. Regional differences or differences between countries in demand and supply conditions of factors are the underlying cause of factor movement.3. This implies that. can be thought of as that in the rural area. has an incentive to move (through multinational firms) to capital-poor. can be interpreted as the demand curve for daily labour in the urban area and the one to the left. DDR. 8. Fig.
This in turn implies that the PPC is a straight line. 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 differences in relative factor endowment also form a basis of comparative advantage. constant labour coefficients imply that the marginal opportunity cost of a good. in free trade. as long as the world terms of trade are different from the domestic exchange ratio. not the underlying cause. The world terms of trade lie in between the domestic exchange ratios. as families of many daily workers prefer to live in rural areas. absolute factor price difference arises because of variations in demand and supply factors in respective regions. is constant. This is because of greater demand for daily labour and less supply of daily labour in the urban areas. In the Ricardian economy. in terms of the other along the PPC. of factor mobility. in the good in which it has comparative advantage. a country’s PPC is same as its consumption possibility curve. Factor endowment theory of trade predicts that a country will export the products which use its relatively abundant factor more intensively. Absolute factor price difference is the immediate cause.150 l INTRODUCTORY MICROECONOMICS l l l l l l l l l l l l l In the Ricardian economy. The greater demand for daily labour in urban areas stems from higher demand for household work and construction projects. A relatively labour – (capital–) abundant country will have comparative advantage in relatively labour – (capital–) intensive goods. In turn. This is captured by the factor endowment theory. as long as the world terms of trade are different from the domestic exchange ratio. a country specialises. Compared to rural areas. The Ricardian theory illustrates that a country benefits from international trade by specialising and exporting the products that it has comparative advantage in. This is true even when a country is more efficient in producing all goods in an absolute sense. Higher cost of living in urban areas implies less supply of daily labour in these areas. A difference in the relative factor endowment causes a difference in the relative factor price. in urban areas. . In the Ricardian economy. the consumption possibility curve in free trade lies outside its PPC. the daily wage rate is higher. In the absence of trade.
15 8. in a two-country Ricardian world economy. Determine the domestic exchange ratio between sitars and guitars in this country.13 Section II 8.9 What is meant by international trade? Give one example of international trade in services.2 8.3 8.COMPARATIVE ADVANTAGE. In an economy. Explain that. What does the Ricardian theory emphasise as a basis of comparative advantage? In the Ricardian theory. The following table gives labour coefficients in the two sectors in two countries. in the free-trade situation.14 8.11 8. INTERNATIONAL TRADE AND FACTOR MOBILITY 151 EXERCISES Section I 8.6 8. 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. 8. Explain the concept of comparative advantage by using a suitable example. 5 units of labour is required to produce one sitar and 12 units of labour is required to produce one guitar.12 8.10 8.5 8. in the Ricardian world economy. Two goods are produced: sitar and guitar. Determine which country has absolute advantage and comparative advantage in which good. What is meant by labour coefficient? Give the meaning of absolute advantage. Give the meaning of comparative advantage.8 8. Explain how. constant labour coefficients imply that the PPC is a straight line.16 Give two examples of international trade in services.4 8.19 . both countries cannot have comparative advantage in producing the same good. which good does a country specialise in free trade? In the no-trade situation.18 8. what is the relationship between a country’s PPC and its consumption possibility curve? In the Ricardian theory.1 8. labour. there is one factor of production.17 8.7 8.
26 8. The world consists of two countries: Blueland and Yellowland. Determine which country now has absolute and comparative advantage in which good. If the world terms of trade facing this country are 1 tooth brush for 4 shoe brushes. Suppose technological progress occurs in Popland. Name two relatively capital-abundant countries. As a result. determine how many tooth brushes and shoe brushes this country will produce in free trade.22 8.27 8.25 8.152 INTRODUCTORY MICROECONOMICS Popland Sitar Guitar 8. Its labour endowment is equal to 1. Name two labour-intensive commodities in India. . If both countries engage in free trade with each other. Name two relatively labour-abundant countries. Explain absolute factor price difference. the labour coefficients are now 40 and 30 respectively for the sitar sector and the guitar sector.21 8. determine which country will export what. labour and land.30 8. Differentiate (with example) between a capital-intensive good and a labour-intensive good. The production of apples is relatively more land intensive compared to grapes.800. Suppose the endowments in the two countries are as given in the following table. A Ricardian economy can produce two goods: tooth brush and shoe brush. Why may it arise? Explain relative factor price difference.29 Refer to the previous question. They produce two goods. Blueland Labour Land 50 70 Yellowland 60 140 8.24 8.20 50 60 Rockland 60 50 8. Name two commodities which are relatively capital-intensive in production.31 Give two instances where factors are mobile.28 8. apples and grapes. There are two factors. The labour coefficients in these two sectors are respectively 30 and 90. Why may it arise? Name two commodities which are relatively labour-intensive in production.23 8.
Analyse why daily wage is higher in urban areas than in rural areas.33 8. Ceteris paribus. Suppose that many of our computer professionals migrate to foreign countries. INTERNATIONAL TRADE AND FACTOR MOBILITY 153 8.34 8. How will it affect the urban and rural wage for these services? Section III 8.35 Explain why a relatively labour-abundant country will export relatively labour-intensive goods.32 Suppose the supply of workers for household services declines in the economy.COMPARATIVE ADVANTAGE. how will it affect the salary of computer professionals in India and abroad? .
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