You are on page 1of 99

( A graphical representation of the alternative combinations of the amounts of

two goods or services that an economy can produce by transferring resources from one good
or service to the other. This curve helps in determining what quantity of a nonessential good or a
service an economy can afford to produce without required production of an essential good or
service. Also called transformation curve .)

Definition of 'Production Possibility Frontier - PPF'

A curve depicting all maximum output possibilities for two or more goods given a
set of inputs (resources, labor, etc.). The PPF assumes that all inputs are used

As indicated on the chart above, points A, B and C represent the points at which
production of Good A and Good B is most efficient. Point X demonstrates the point
at which resources are not being used efficiently in the production of both goods;
point Y demonstrates an output that is not attainable with the given inputs.

Businesses have limited resources, and owners and managers make difficult choices about
how best to allocate what they have. One tool they use to do so is a production possibility
curve, which displays the different combinations of two items that a business can make with
the same fixed combination of resources. Armed with that information, business owners pick
the combination that best fits the company and market demand.

A curve that illustrates the production possibilities of an economy--the alternative

combinations of two goods that an economy can produce with given resources and
Production Possibilities Curve

technology. A production possibilities curve (PPC) represents the boundary or frontier of the
economy's production capabilities, hence it is also frequently termed a production
possibilities frontier (PPF). As a frontier, it is the maximum production possible given
existing (fixed) resources and technology. Producing on the curve means resources are fully
employed, while producing inside the curve means resources are unemployed. The law of
increasing opportunity cost is what gives the curve its distinctive convex shape.

Production possibilities is an analysis of the alternative combinations of two goods that

aneconomy can produce with existingresources and technology in a given time period. This
analysis is often represented by a convexcurve.

A standard production possibilities curve for a hypothetical economy is presented here. This
particular production possibilities curve illustrates the alternative combinations of two
goods--crab puffs and storage sheds--that can be produced by the economy.
The Set Up
According to the assumptions of production possibilities analysis, the
State of the ECONOMY
economy is using all resources with given technology to efficiently
produce two goods--crab puffs and storage sheds. Crab puffs are Housing Starts
delicious cocktail appetizers which have the obvious use of being July 2014
eaten by hungry people, usually at parties. Storage sheds are small 1,093,000
buildings used to store garden implements, lawn mowers, and Up 15.7% from June
bicycles. '14: Source:U.S. Dept.
of Com.
This curve presents the alternative combinations of crab puffs and
storage sheds that the economy can produce. Production is
More Stats
technically efficient, using all existing resources, given existing
technology. The vertical axismeasures the production of crab puffs

Production Possibilities Schedule

[What's This?]

Today, you are likely to spend

a great deal of time flipping
through mail order catalogs
hoping to buy either a large
red and white striped beach
towel or a bottle of
blackcherry flavored spring
and the horizontal axis measures the production of storage sheds. water. Be on the lookout for
bottles of barbeque sauce
The production possibilities curve should be compared with that act TOO innocent.
theproduction possibilities schedule, such as the one presented to Your Complete Scope
the left. A schedule presents a limited, discrete number of
production alternatives in the form of a table. The production This isn't me! What am I?
possibilities curve, in contrast, presents an infinite number of
production alternatives that reside on the boundary of the frontier.
The production possibilities schedule is commonly used as a starting
point in the derivation of the production possibilities curve. Okun's Law posits that
the unemployment rate
Key Economic Concepts increases by 1% for
As a introductory model of the economy, the production possibilities every 2% gap between
curve is commonly used to illustrate basic economic concepts, real GDP and full-
including full employment, unemployment, opportunity employment real GDP. of Diminishing Marginal Utility - Detailed
Note: There are two laws of utility that are often discussed together: law of diminishing marginal
utility and the law of equi-marginal utility. This article explains the law of diminishing marginal utility.

The law of diminishing marginal utility is an important concept to understand. It basically falls in the
category of Microeconomics, but it is of equal and significant importance in our day-to-day decisions.
In this article, you will find the definition of the law of diminishing marginal utility, its detailed
explanation with the help of a schedule and diagram, assumptions we make in the law of diminishing
marginal utility and the exceptions where the law of diminishing marginal utility does not apply.

We will first start with the basic definition of Utility.


Utility is the capacity of a commodity through which human wants are satisfied.

Law of Diminishing Marginal Utility:

The law of diminishing marginal utility is comprehensively explained by Alfred Marshall. According to
his definition of the law of diminishing marginal utility, the following happens:

During the course of consumption, as more and more units of a commodity are used, every
successive unit gives utility with a diminishing rate, provided other things remaining the same;
although, the total utility increases.


'Utils' is considered as the measurable 'unit' of utility.

Explanation for the Law of Diminishing Marginal Utility:

We can briefly explain Marshalls theory with the help of an example. Assume that a consumer
consumes 6 apples one after another. The first apple gives him 20 utils (units for measuring utility).
When he consumes the second and third apple, the marginal utility of each additional apple will be
lesser. This is because with an increase in the consumption of apples, his desire to consume more
apples falls.

Therefore, this example proves the point that every successive unit of a commodity used gives the
utility with the diminishing rate.

We can explain this more clearly with the help of a schedule and diagram.

Schedule for Law of Diminishing Marginal Utility:

Unit of Consumption Marginal Utility Total Utility

1 20 20

2 15 35

3 10 45

4 05 50

5 00 50

6 -05 45

The schedule explains that with each additional unit consumed the marginal utility increases with a diminishing rate.
After the saturation point though, the utility starts to fall.

In the above table, the total utility obtained from the first apple is 20 utils, which keep on increasing
until we reach our saturation point at 5th apple. On the other hand, marginal utility keeps on
diminishing with every additional apple consumed. When we consumed the 6th apple, we have gone
over the limit. Hence, the marginal utility is negative and the total utility falls.

With the help of the schedule, we have made the following diagram:
Saturation Point: The point where the desire to consume the same product anymore becomes

Disutility: If you still consume the product after the saturation point, the total utility starts to fall. This
is known as disutility.

When the first apple is consumed, the marginal utility is 20. When the second apple is consumed,
the marginal utility increases by 15 utils, which is less than the marginal utility of the 1 st apple
because of the diminishing rate. Therefore, we have shown that the utility of apples consumed
diminishes with every increase of apple consumed.

Similarly, when we consumed the 5th apple, we are at our saturation point. If we consume another
apple, i.e. 6th apple, we can see that the marginal utility curve has fallen to below X-axis, which is
also known as disutility.

The unit and its quality must remain same.

Assumptions in the Law of Diminishing Marginal Utility:

For the law of diminishing marginal utility to be true, we need to make certain assumptions. Each
assumption is quite logical and understandable. If any of the assumptions are not true in the case,
the law of diminishing marginal utility will not be true.
Following are the assumptions in the law of diminishing marginal utility:

The quality of successive units of goods should remain the same. If the quality of the goods
increase or decrease, the law of diminishing marginal utility may not be proven true.
Consumption of goods should be continuous. If there comes a substantial break in the
consumption of goods, the actual concept of diminishing marginal utility will be altered.
Consumers mental outlook should not change.

Unit of good should not be very few or small. In such a case, the utility may not be measured

Exceptions for the Law of Diminishing Marginal Utility:

The law of diminishing marginal utility states that with the consumption of every successive unit of
commodity yields marginal utility with a diminishing rate. However, there are certain things on which
the law of diminishing marginal utility does not apply.

Following are the exceptions for this law:

Desire for money.

Desire for knowledge.

Use of liquor or wine.

Collection of rare objects.

13Law of Equi Marginal Utility:

The law of equi marginal utility was presented in 19th century by an Australian economists H. H.
Gossen. It is also known as law of maximum satisfaction or law of substitution or Gossen's second law. A
consumer has number of wants. He tries to spend limited income on different things in such a way that
marginal utility of all things is equal. When he buys several things with given money income he equalizes
marginal utilities of all such things. The law of equi marginal utility is an extension of thelaw of diminishing
marginal utility. The consumer can get maximum utility by allocating income among commodities in such
a way that last dollar spent on each item provides the same marginal utility.


"A person can get maximum utility with his given income when it is spent on different commodities in such
a way that the marginal utility of money spent on each item is equal".

It is clear that consumer can get maximum utility from the expenditure of his limited income. He should
purchase such amount of each commodity that the last unit of money spend on each item provides same
marginal utility.

Assumptions of the Law of Equi Marginal Utility:

1. There is no change in the prices of the goods.

2. The income of consumer is fixed.

3. The marginal utility of money is constant.

4. Consumer has perfect knowledge of utility obtained from goods.

5. Consumer is normal person so he tries to seek maximum satisfaction.

6. The utility is measurable in cardinal terms.

7. Consumer has many wants.

8. The goods have substitutes.

Explanation With Schedule and Diagram:

The law of substitution can be explained with the help of an example. Suppose consumer has six dollars
that he wants to spend on apples and bananas in order to obtain maximum total utility. The following table
shows marginal utility (MU) of spending additional dollars of income on apples and bananas:

Money (Units) MU of apples MU of bananas

1 10 8

2 9 7

3 8 6

4 7 5

5 6 4

6 5 3

The above schedule shows that consumer can spend six dollars in different ways:

1. $1 on apples and $5 on bananas. The total utility he can get is:

[(10) + (8+7+6+5+4)] = 40.

2. $2 on apples and $4 on bananas. The total utility he can get is:

[(10+9) + (8+7+6+5)] = 45.

3. $3 on apples and $3 on bananas. The total utility he can get is:

[(10+9+8) + (8+7+6)] = 48.

4. $4 on apples and $2 on bananas. This way the total utility is:

[(10+9+8+7) + (8+7)] = 49.

5. $5 on apples and $1 on bananas. The total utility he can get is:

[(10+9+8+7+6) + (8)] = 48.

Total total utility for consumer is 49 utils that is the highest obtainable with expenditure of $4 on apples
and $2 on bananas. Here the condition MU of apple = MU of banana i.e 7 = 7 is also satisfied. Any other
allocation of the last dollar shall give less total utility to the consumer.

The same information can be used for graphical presentation of this law:
The diagram shows that consumer has income of six dollars. He wants to spend this money on apples
and bananas in such a way that there is maximum satisfaction to the consumer.


1. The law is not applicable in case of knowledge. Reading of books provides more satisfaction and
knowledge to the scholar. Different books provide variety of knowledge and satisfaction.

2. The law is not applicable in case of indivisible goods. The consumer is unable to divide the goods
to adjust units of utility derived from consumption of goods.

3. There is no measurement of utility. It is psychological concept. It is not possible to express it into

quantitative form.

4. The law does not hold well in case fashion and customs. The people like to spend money on
birthdays, marriages and deaths.

5. The does not hold well in case of very low income. The maximization of utility is not possible due
to low income.

6. The law is not applicable in case of durable goods. The calculation of marginal utility of durable
goods is impossible.

7. The law fails when goods of choice are not available. The consumer is bound to use commodity,
which provides low utility due to non availability of goods having high utility.

8. There are certain lazy consumers. They do not care for maximum utility. The law fails to operate
in case of laziness of consumers. They go on consuming goods with comparing utility.

9. It does not work when there are frequent prices changes. The consumer is unable to calculate
utility of different commodities. Changing price levels create confusion in the minds of consumers.
10. There may be unlimited resources. The does not work due to unlimited resources. There is no
need to change the direction of expenditure from one item to another when there are gifts of


1. The law of equi marginal utility is helpful in the field of production. The producer has
limited resources. He uses limited resources to purchase production factors. He tries to
equalize marginal utility of all factors. He wishes to get maximum output and profit.

2. National income is distributed among factors of production according to this law. An

entrepreneur can pay factors of production equal to marginal product measured in
money terms. He will substitute one factor for another until marginal productivity of all
factors is equal to prices of their services.

3. The law is used in the field of exchange. The people like to exchange a commodity
having low utility with a commodity having high utility. There is maximum benefit from
exchange of commodities. The law is helpful in exchange of wealth, trade, import and

4. The law is applicable in consumption. A rational consumer tries to get maximum

satisfaction when he spends his limited resources on various things. He tries to
equalize weighted marginal utility of all the things.

5. The law is applicable in public finance. The government can spend its revenue to get
maximum social advantage. The marginal utility of each dollar spent in one sector must
be equal to marginal utility derived from all other sectors.

6. The law is useful for workers in allocating the time between work and rest. They can
compare the marginal utility of work and the marginal utility of rest. They can decide
working hours and rest hours.

7. The law holds well in case of saving and spending. The consumer can make choice
between present wants and future wants. He can feel that a dollar saved has greater
utility than a dollar spent, he can save more and spend less. He will substitute saving
and spending till marginal utility of a dollar spent and a dollar saved are equal.

8. The law is helpful in prices. Due to scarcity of commodity its prices go up. The law tells
us to use substitute commodity, which is less scarce. The result is that the price of
commodity comes down.


The law of equi-marginal utility states that A rational person
in order to get maximum satisfaction allocates his expenditures on
purchase of different goods in such a way that marginal utility of the
last Rs. Spent in each direction is the same.
This is called the law of satisfaction because we substitute more useful
goods to less useful goods. This is called the law of maximum
satisfaction because through it we get maximum satisfaction and it is
called the law of equi-marginal utility because through it when the
marginal utilities are equalized, through the process of substitution,
the maximum satisfaction is attained.

Following are the assumptions of the law.
Independent Utilities:
The marginal utilities of different commodities should be independent of each
other and diminishes with more and more purchase.
Marginal Utility of Money:
The marginal utility of money should remain constant for the consumer as he
spends more and more of it on the purchase of goods.
Every consumer should be rational in the purchase of goods. His aim should be
to maximize the total utility and nothing else.
Substitution of Goods:
It is assumed that goods are naturally substitutes of each other. The result of
substitution will be the MU of one commodity will fall and that of another commodity
will rise.
Awareness of Market:
It is assumed that consumer has much awareness about the market.
Divisibility of Goods:
The law is based on the assumption that goods are divisible in small units.

Following are the limitations of the law.
No Rational Calculation:
The law involves rational calculations. But in the busy and routine life we are
not capable to do so that who is rational and who is irrational.
Consumers Ignorance:
The consumer may not aware of the goods which are more useful than the
goods which they are going to purchase. So, they cannot substitute more useful goods
to the less useful goods and hence the law is not applicable to them.
Indivisibility of Goods:
Sometimes the goods are not divisible to small units. So MU cannot be
calculated and law is not applicable.
Wrong Assumptions:
It assumed that utilities are measurable but in actual utility cannot be
calculated because it is a state of mind. It is assumed that marginal utility of money
remains constant but the law of DMU applies to money equally.

This law is applied to all problems of scarce (limited) resource against unlimited
This law plays an important role in the theory of distribution and exchange.
It extends over the field of the theory of production.

Thus the law of substation applies in all branches of economic theories.


All consumers strive to maximize their utility. We try to get as much satisfaction as we
can. The consumers scale of preference is derived by means of indifference mapping
that is a set of indifference curves which ranks the preferences of the consumer.
Getting to the indifference curve which is farthest from the origin gives the highest total
utility. Although the goal of the consumer is maximization of satisfaction, the means of
achieving the goal is not clear. Higher indifference curve not only gives higher
satisfaction but also are more expensive. Here we are confronted with the basic
conflict between preferences and the prices of the commodities consumer wants to
consume. With a given amount of money income to spent, we cannot attain the highest
satisfaction but have to settle for less.

How to Derive Consumer's Equilibrium Through the

Technique of Indifference Curve and Budget Line?
How Do Income Effect, Substitution Effect and Price Effect Influence Consumer's
The Hicksian Method and The Slutskian Method

The goal of a consumer is to get maximum satisfaction from the commodities he purchases. At the
same time, the consumer possesses limited resources. Hence, he is trying to maximize his
satisfaction by allocating the available resources (money income) among various goods and
services rationally. This is the main theme of the theory of consumer behavior. Further, you could
ascertain that a consumer is in equilibrium when he obtains maximum satisfaction from his
expenditure on the commodities given the limited resources. You can analyze consumers
equilibrium through the technique of indifference curve and budget line.


1. The consumer under consideration is a rational human being. This means that the consumer
always tries to maximize his satisfaction with limited resources.

2. There prevails perfect competition in the market.

3. Goods are homogeneous and divisible.

4. The consumer has perfect knowledge about the products available in the market. For
instance, prices of commodities.

5. Prices of commodities and consumers money income are given.

6. Consumers indifference map remains unchanged throughout the analysis.

7. Consumers tastes, preferences and spending habits remain unchanged throughout the

Price Line or Budget Line

Price line or budget line is an important concept in analyzing consumers equilibrium. According to
Prof. Maurice, The budget line is the locus of combinations or bundles of goods that can be
purchased if the entire money income is spent.

Table 1

Total Amount Spent on X

X (units) Y (units)
+ Y (in $)

4 0 8+0=8

3 2 6+2=8

2 4 4+4=8

1 6 2+6=8

0 8 0+8=8
Suppose there are two commodities, namely X and Y. Given the market prices and the consumers
income, the price line shows all the possible combinations of X and Y that a consumer could
purchase at a particular time. Let us consider a hypothetical consumer who has a fixed income of
$8. Now, he wants to spend the entire money on two commodities (X and Y). Suppose the price of
commodity X is $2, and the price of commodity Y $1. The consumer could spend all money on X and
get 4 units of commodity X and no commodity Y. Alternatively, he could spend entire money on
commodity Y and get 8 units of commodity Y and no commodity X. The table given below exhibits
the numerous combinations of X and Y that the consumer can purchase with $8.

In figure 1, horizontal axis measures commodity X and vertical axis measure commodity Y. The
budget line or price line (LM) indicates various combinations of commodity X and commodity Y that
the consumer can buy with $8. The slope of the budget line is OL/OM. At point Q, the consumer is is
able to buy 6 units of commodity Y and 1 unit of commodity X. Similarly, at point P, he is able to buy
4 units of commodity Y and 2 units of commodity X.

The slope of the price line (LM) is the ratio of price of commodity X to price of commodity Y, i.e.,
Px/Py. In our example, price of commodity X is $2 and price of commodity Y is $1; hence, the slope of
the price line is Px. Note that the slope of the budget line depends upon two factors: (a) money
income of the consumer and (b) prices of the commodities under consideration.

Reasons for Many Budget Lines

(a) Consumers Income Change

An outward parallel shift in the budget line occurs because of an increase in consumers money
income provided that the prices of commodities X and Y remain unchanged (it means constant slope
- Px/Py). Likewise, a reduction in consumers money income creates a parallel inward shift in the
budget line.
In figure 2, LM denotes the initial price line. Assume that the prices of the two goods and consumers
money income are constant. Now, the consumer is able to purchase OM quantity of commodity X or
OL quantity of commodity Y. If his income increases, the price line shifts outward and becomes L 1M1.
He can now buy OM1quantity of commodity X and OL1 quantity of commodity Y. A further increase in
income causes a further outward shift in the price line to L 2M2. Price line L2M2indicates that the
consumer can buy OM2 quantity of commodity X and OL2quantity of commodity Y. Similarly, if there is
a decrease in consumers income, the price line will shift inward (for example, L 3M3).

(b) Price Change

The slope of a price line is associated with the prices of commodities under consideration. Hence, if
there is a change in the price of any one of the commodities, there will be a change in the slope of
the price line. Assume that the price of commodity X decreases and the price of commodity Y remain
unchanged. In this case, the price ratio Px/Py (slope of price line) tends to decrease. In figure 3, this
scenario is denoted by the shifts in the price line from LM to LM1 then to LM2and so on. Conversely, if
the price of commodity X rises, the price ratio Px/Py will rise. This leads to the price line shifts from
LM2 to LM1 and to LM.
Indifference Map

A set of indifference curves that shows a consumers preferences is known as an indifference map.
The indifference map of a consumer, since is composed of indifference curves, exhibits all properties
of a normal indifference curve. Some of the most important properties of an indifference curve are:
indifference curves are convex to the origin; they always slope downwards from left to right; higher
indifference curves indicate higher levels of satisfaction; they do not touch any of the axes (example:
figure 4).

Necessary conditions for consumers equilibrium

The following are the two important conditions to attain consumers equilibrium:

Firstly, marginal rate of substitution must be equal to the ratio of commodity prices. Symbolically,

MRSxy = MUx/MUY = Px/Py.

Secondly, indifference curve must be convex to the origin.

Consumer's Equilibrium
Now we have both budget lines and indifference map of the consumer. A budget line represents
consumers limited resources (what is feasible) and indifference map represent consumers
preferences (what is desirable). The question now is that how the consumer is going to optimize his
limited resources. An answer for this question would be consumers equilibrium. In other words, the
consumers equilibrium means the combination of commodities that maximizes utility, given the
budget constraint. To obtain consumers equilibrium graphically, you just need to superimpose the
budget line on the consumers indifference map. This is shown in figure 5.

At point E, consumers equilibrium is attained. Because the indifference curve IC 2is the best possible
indifference curve that the consumer can reach with the given resources (budget line). The tangency
of indifference curve IC2 and the price line represent the above statement. At the point of tangency,
the slope of the budget line (Px/Py) and the marginal rate of substitution (MRSxy = MUx/MUy) are
equal: MUx/MUy = Px/Py (first condition for consumers equilibrium). From figure 5, we can
understand that the second condition for consumers equilibrium (indifference curve must be convex
to the origin) is also fulfilled.
A small algebraic manipulation in the above equation gives us MU x/Px = MUy/Py, which is the
marginal utility per dollar rule for consumers equilibrium. Thus, all the conditions for consumers
equilibrium are fulfilled. The combination (X0Y0) is an optimal choice (point E) for the consumer.

17. Demand and supply equilibrium


Conversely, consider a situation where the price in a market is higher

than the equilibrium price. If the price is higher than P*, the quantity
supplied in that market will be higher than the quantity demanded at
the prevailing price, and a surplus will result. (This time, the size of the
surplus is given by the quantity supplied minus the quantity
demanded.) When a surplus occurs, firms either accumulate inventory
(which costs money to store and hold) or they have to discard their
extra output. This is clearly not optimal from a profit perspective, so
firms will respond by cutting prices and production quantities when
they have the opportunity to do so. This behavior will continue as long
as a surplus remains, again bringing the market back to the
intersection of supply and demand.

17:Equilibrium, Changes in Supply and Demand, and

Price Ceiling and Floors
<< Previous Next >>

Supply and demand come together in the marketplace. With a downward-sloping demand curve and an
upward-sloping supply curve, there will ordinarily be a point of intersection of the two curves. That point
shows the price at which the quantity demanded in the market equals the quantity supplied. This is called
anequilibrium point, and the corresponding price is the equilibrium price while the corresponding
quantity is the equilibrium quantity. At equilibrium, there is no tendency for price or quantity to

Consider now prices below the equilibrium price. The quantity demanded will be greater than the quantity
supplied. This is referred to as excess demand, or ashortage. In the face of a shortage, consumers will
compete with one another for the limited supply, and this will result in an increase in the price of the
product. The increase in price will stimulate a reduction in quantity demanded and an increase in quantity
supplied (movements up along the demand curve and the supply curve) until the equilibrium point is
reached. Conversely, at prices above the equilibrium price, quantity demanded will be smaller than the
quantity supplied, and there will be excess supply (a surplus) in the market. With a surplus, firms will
compete to sell their products, and this will result in downward pressure on the price of the product. As
with a shortage, there will be movements along the supply and demand curves as price changes, until the
equilibrium point is reached.

Changes in Supply and Demand

When supply and demand curves shift, this results in changes to the equilibrium price and quantity. For
example, if there is an increase in demand (a shift to the right of the demand curve, as might occur with
higher incomes, higher prices for a substitute good, or stronger tastes for the product in question), both
the equilibrium price and equilibrium quantity will increase. A decrease in demand will entail reductions in
the equilibrium price and quantity. If there is an increase in supply (a shift to the right of the supply curve,
as might occur with improved technology or reduction in the prices of inputs), this will result in a decline in
the equilibrium price and an increase in the equilibrium quantity. Conversely, a decrease in supply will
raise the equilibrium price and lower the equilibrium quantity.

You can see these changes by starting with a simple supply and demand graph showing an initial
equilibrium, and then drawing the new demand or supply curve and observing the new equilibrium point.
In order to do well in this course, you will need to become proficient at drawing supply and demand
graphs and using them to determine the consequences of changes in demand, supply, or both.
The four basic changes (increase in demand, decline in demand, increase in supply, reduction in supply)
are illustrated in the diagrams below. Note that in each case, there is a movement along the curve for the
aspect that does not change. That is, when demand increases, there is an increase in the quantity
supplied (movement along the supply curve) as the market moves from the initial equilibrium price to the
new equilibrium price. Likewise, when there is an increase in supply, there is an increase in the quantity
demanded (downward movement along the demand curve).

1. An increase in demand 2. A decline in demand

3. An increase in supply 4. A decline in supply

Price Ceilings and Floors

We noted above that shortages and surpluses are not equilibrium situations, and that markets allowed to
adjust to shortages or surpluses will move to equilibrium. But sometimes markets are subject to
regulations that prevent them from adjusting to shortages or surpluses. This is especially the case with
price ceilings and price floors. The video at right illustrates how Germany instituted price controls after
World War II.

A price ceiling is a maximum price that sellers may charge for a good or


. Normally this maximum price is established by some governmental authority. A classic example of price
ceilings is provided by rent controls, where cities establish maximum rents in an effort to keep housing
affordable. If this ceiling keeps the market price below the equilibrium price, it creates a shortage that
persists (since the market price is prevented from rising to its equilibrium level).

When price ceilings are in effect and the ceiling price is below the equilibrium price, it is no longer the
case that supply, demand, and price alone can serve to allocate the product to different consumers. The
product must be rationed via nonprice mechanisms as well. Allocation in these circumstances may be
based on queuing (lining up to wait for distribution of the good or service), rationing coupons, or black
markets (where illegal trading takes place at market-determined prices).

A price floor is a minimum price that must be paid in a market i.e., exchange at a lower price is
prohibited. Governmental bodies typically establish price floors. Two examples are the minimum wage
and support prices for agricultural products. If a price floor keeps the market price above the equilibrium
price, it creates a surplus that persists (since the market price is prevented from falling to its equilibrium
level). This surplus typically will create some problems. In the minimum wage example, it may contribute
to higher unemployment than would exist in the absence of a minimum wage, and in the farm price
support example it will translate into a need to cope with growing surpluses of agricultural products.
Again, nonprice rationing will be utilized.

Practice Problem 1: Equilibrium, Changes in Supply and Demand and Price eilings and Floors

If the actual price of a good is above the equilibrium price, what will likely happen to the price, the quantity
demanded, and the quantity supplied?

If the actual price of a good is above the equilibrium price, then there will be excess supply of that product
(Qs > Qd). There will be a tendency for the price of the product to drop. As this happens, the quantity
supplied will also decrease, and the quantity demanded will increase until Qd = Qs.

The equilibrium price is the price at which the quantity demanded equals the quantity
supplied. It is determined by the intersection of the demand and supply curves.
A surplus exists if the quantity of a good or service supplied exceeds the quantity
demanded at the current price; it causes downward pressure on price. A shortage exists if
the quantity of a good or service demanded exceeds the quantity supplied at the current
price; it causes upward pressure on price.
An increase in demand, all other things unchanged, will cause the equilibrium price to
rise; quantity supplied will increase. A decrease in demand will cause the equilibrium price
to fall; quantity supplied will decrease.
An increase in supply, all other things unchanged, will cause the equilibrium price to
fall; quantity demanded will
increase. A decrease in supply will cause the equilibrium price to rise; quantity
demanded will decrease.
To determine what happens to equilibrium price and equilibrium quantity when both
the supply and demand curves shift, you must know in which direction each of the curves
shifts and the extent to which each curve shifts.
The circular flow model provides an overview of demand and supply in product and
factor markets and suggests how these markets are linked to one another.

40.Commercial Bank: Definition, Function, Credit

Creation and Significances
Commercial Bank: Definition, Function, Credit Creation and Significances!

Meaning of Commercial Banks:

A commercial bank is a financial institution which performs the functions of accepting

deposits from the general public and giving loans for investment with the aim of earning

In fact, commercial banks, as their name suggests, axe profit-seeking institutions, i.e.,
they do banking business to earn profit.

They generally finance trade and commerce with short-term loans. They charge high
rate of interest from the borrowers but pay much less rate of Interest to their depositors
with the result that the difference between the two rates of interest becomes the main
source of profit of the banks. Most of the Indian joint stock Banks are Commercial
Banks such as Punjab National Bank, Allahabad Bank, Canara Bank, Andhra Bank,
Bank of Baroda, etc.

Functions of Commercial Banks (D05, 06, 07,08C,

09,09C, A05, 06, 08, and 09):

The two most distinctive features of a commercial bank are borrowing and lending, i.e.,
acceptance of deposits and lending of money to projects to earn Interest (profit). In
short, banks borrow to lend. The rate of interest offered by the banks to depositors is
called the borrowing rate while the rate at which banks lend out is called lending rate.
The difference between the rates is called spread which is appropriated by the banks.
Mind, all financial institutions are not commercial banks because only those which
perform dual functions of (i) accepting deposits and (ii) giving loans are termed as
commercial banks. For example post offices are not bank because they do not give
loans. Functions of commercial banks are classified in to two main categories(A)
Primary functions and (B) Secondary functions.

Let us know about each of them:

(A) Primary Functions:

1. It accepts deposits:

A commercial bank accepts deposits in the form of current, savings and fixed deposits.
It collects the surplus balances of the Individuals, firms and finances the temporary
needs of commercial transactions. The first task is, therefore, the collection of the
savings of the public. The bank does this by accepting deposits from its customers.
Deposits are the lifeline of banks.

Deposits are of three types as under:

(i) Current account deposits:


Such deposits are payable on demand and are, therefore, called demand deposits.
These can be withdrawn by the depositors any number of times depending upon the
balance in the account. The bank does not pay any Interest on these deposits but
provides cheque facilities. These accounts are generally maintained by businessmen
and Industrialists who receive and make business payments of large amounts through

(ii) Fixed deposits (Time deposits):

Fixed deposits have a fixed period of maturity and are referred to as time deposits.
These are deposits for a fixed term, i.e., period of time ranging from a few days to a few
years. These are neither payable on demand nor they enjoy cheque facilities.

They can be withdrawn only after the maturity of the specified fixed period. They carry
higher rate of interest. They are not treated as a part of money supply Recurring deposit
in which a regular deposit of an agreed sum is made is also a variant of fixed deposits.

(iii) Savings account deposits:

These are deposits whose main objective is to save. Savings account is most suitable
for individual households. They combine the features of both current account and fixed
deposits. They are payable on demand and also withdraw able by cheque. But bank
gives this facility with some restrictions, e.g., a bank may allow four or five cheques in a
month. Interest paid on savings account deposits in lesser than that of fixed deposit.

Difference between demand deposits and time (term) deposits:

Two traditional forms of deposits are demand deposit and term (or time) deposit:

(i) Deposits which can be withdrawn on demand by depositors are called demand
deposits, e.g., current account deposits are called demand deposits because they are
payable on demand but saving account deposits do not qualify because of certain
conditions on withdrawal. No interest is paid on them. Term deposits, also called time
deposits, are deposits which are payable only after the expiry of the specified period.

(ii) Demand deposits do not carry interest whereas time deposits carry a fixed rate of

(iii) Demand deposits are highly liquid whereas time deposits are less liquid,

(iv) Demand deposits are chequable deposits whereas time deposits are not.

2. It gives loans and advances:

The second major function of a commercial bank is to give loans and advances
particularly to businessmen and entrepreneurs and thereby earn interest. This is, in fact,
the main source of income of the bank. A bank keeps a certain portion of the deposits
with itself as reserve and gives (lends) the balance to the borrowers as loans and
advances in the form of cash credit, demand loans, short-run loans, overdraft as
explained under.

(i) Cash Credit:

An eligible borrower is first sanctioned a credit limit and within that limit he is allowed to
withdraw a certain amount on a given security. The withdrawing power depends upon
the borrowers current assets, the stock statement of which is submitted by him to the
bank as the basis of security. Interest is charged by the bank on the drawn or utilised
portion of credit (loan).

(ii) Demand Loans:

A loan which can be recalled on demand is called demand loan. There is no stated
maturity. The entire loan amount is paid in lump sum by crediting it to the loan account
of the borrower. Those like security brokers whose credit needs fluctuate generally, take
such loans on personal security and financial assets.

(iii) Short-term Loans:

Short-term loans are given against some security as personal loans to finance working
capital or as priority sector advances. The entire amount is repaid either in one
instalment or in a number of instalments over the period of loan.


Commercial banks invest their surplus fund in 3 types of securities:

(i) Government securities, (ii) Other approved securities and (iii) Other securities. Banks
earn interest on these securities.

(B) Secondary Functions:

Apart from the above-mentioned two primary (major) functions, commercial banks
perform the following secondary functions also.

3. Discounting bills of exchange or bundles:

A bill of exchange represents a promise to pay a fixed amount of money at a specific
point of time in future. It can also be encashed earlier through discounting process of a
commercial bank. Alternatively, a bill of exchange is a document acknowledging an
amount of money owed in consideration of goods received. It is a paper asset signed by
the debtor and the creditor for a fixed amount payable on a fixed date. It works like this.

Suppose, A buys goods from B, he may not pay B immediately but instead give B a bill
of exchange stating the amount of money owed and the time when A will settle the debt.
Suppose, B wants the money immediately, he will present the bill of exchange (Hundi)
to the bank for discounting. The bank will deduct the commission and pay to B the
present value of the bill. When the bill matures after specified period, the bank will get
payment from A.

4. Overdraft facility:

An overdraft is an advance given by allowing a customer keeping current account to

overdraw his current account up to an agreed limit. It is a facility to a depositor for
overdrawing the amount than the balance amount in his account.

In other words, depositors of current account make arrangement with the banks that in
case a cheque has been drawn by them which are not covered by the deposit, then the
bank should grant overdraft and honour the cheque. The security for overdraft is
generally financial assets like shares, debentures, life insurance policies of the account
holder, etc.

Difference between Overdraft facility and Loan:

(i) Overdraft is made without security in current account but loans are given against

(ii) In the case of loan, the borrower has to pay interest on full amount sanctioned but in
the case of overdraft, the borrower is given the facility of borrowing only as much as he

(iii) Whereas the borrower of loan pays Interest on amount outstanding against him but
customer of overdraft pays interest on the daily balance.

5. Agency functions of the bank:

The bank acts as an agent of its customers and gets commission for performing
agency functions as under:

(i) Transfer of funds:

It provides facility for cheap and easy remittance of funds from place-to-place through
demand drafts, mail transfers, telegraphic transfers, etc.

(ii) Collection of funds:

It collects funds through cheques, bills, bundles and demand drafts on behalf of its

(iii) Payments of various items:

It makes payment of taxes. Insurance premium, bills, etc. as per the directions of its

(iv) Purchase and sale of shares and securities:

It buys sells and keeps in safe custody securities and shares on behalf of its customers.

(v) Collection of dividends, interest on shares and debentures is made on behalf of its

(iv) Acts as Trustee and Executor of property of its customers on advice of its

(vii) Letters of References:

It gives information about economic position of its customers to traders and provides
similar information about other traders to its customers.

6. Performing general utility services:

The banks provide many general utility services, some of which are as under:

(i) Travellers cheques .The banks issue travelers cheques and gift cheques.
(ii) Locker facility. The customers can keep their ornaments and important documents in
lockers for safe custody.

(iii) Underwriting securities issued by government, public or private bodies.


(iv) Purchase and sale of foreign exchange (currency).

Credit (Money) Creation by Commercial Banks (A10;

D10, 10C, 11, 11C):

RBI produces money while commercial banks increase the supply of money by creating
credit which is also treated as money creation. Commercial banks create credit in the
form of secondary deposits.

Mind, total deposits of a bank is of two types:

(i) Primary deposits (initial cash deposits by the public) and (ii) Secondary deposits
(deposits that arise due to loans given by the banks which are assumed to be
redeposited in the bank.) Money creation by commercial banks is determined by two
factors namely (i) Primary deposits i.e. initial cash deposits and (ii) Legal Reserve Ratio
(LRR), i.e., minimum ratio of deposits which is legally compulsory for the commercial
banks to keep as cash in liquid form. Broadly when a bank receives cash deposits from
the public, it keeps a fraction of deposits as cash reserve (LRR) and uses the remaining
amount for giving loans. In the process of lending money, banks are able to create
credit through secondary deposits many times more than initial deposits (primary

How? It is explained below.

Process of money (credit) creation:

Suppose a man, say X, deposits Rs 2,000 with a bank and the LRR is 10%, which
means the bank keeps only the minimum required Rs 200 as cash reserve (LRR). The
bank can use the remaining amount Rs 1800 (= 2000 200) for giving loan to
someone. (Mind, loan is never given in cash but it is redeposited in the bank as demand
deposit in favour of borrower.) The bank lends Rs 1800 to, say, Y who is actually not
given loan but only demand deposit account is opened in his name and the amount is
credited to his account.

This is the first round of credit creation in the form of secondary deposit (Rs 1800),
which equals 90% of primary (initial) deposit. Again 10% of Ys deposit (i.e., Rs 180) is
kept by the bank as cash reserve (LRR) and the balance Rs 1620 (=1800 180) is
advanced to, say, Z. The bank gets new demand deposit of Rs 1620. This is second
round of credit creation which is 90% of first round of increase of Rs 1800. The third
round of credit creation will be 90% of second round of 1620. This is not the end of

The process of credit creation goes on continuously till derivative deposit (secondary
deposit) becomes zero. In the end, volume of total credit created in this way becomes
multiple of initial (primary) deposit. The quantitative outcome is called money multiplier.
If the bank succeeds in creating total credit of, says Rs 18000, it means bank has
created 9 times of primary (initial) deposit of Rs 2000. This is what is meant by credit

In short, money (or credit) creation by commercial banks is determined by (i) amount of
initial (primary) deposits and (ii) LRR. The multiple is called credit creation or money


Total Credit creation = Initial deposits x 1/LPR.

Money Multiplier:

It means the multiple by which total deposit increases due to initial (primary) deposit.
Money multiplier (or credit multiplier) is the inverse of Legal Reserve Ratio (LRR). If
LRR is 10%, i.e., 10/100or 0.1, then money multiplier = 1/0.1 = 10.

Smaller the LRR, larger would be the size of money multiplier credited to his account.
He is simply given the cheque book to draw cheques when he needs money. Again,
20% of Sohans deposit which is considered a safe limit is kept for him by the bank and
the balance Rs 640 (= 80% of 800) is advanced to, say, Mohan. Thus, the process of
credit creation goes on continuously and in the end volume of total credit created in this
way becomes multiple of initial cash deposit.

The bank is able to lend money and charge interest without parting with cash because
the bank loan simply creates a deposit (or credit) for the borrower. If the bank succeeds
in creating credit of, say, Rs 15,000, it means that the bank has created credit 15 times
of the primary deposit of Rs 1,000. This is what is meant by credit creation.

Similarly, the bank creates credit when it buys securities and pays the seller with its own
cheque. The cheque is deposited in some bank and a deposit (credit) is created for the
seller of securities. This is also called credit creation. As a result of credit creation,
money supply in the economy becomes higher. It is because of this credit creation
power of commercial banks (or banking system) that they are called factories of credit
or manufacturer of money.

Types of Commercial Banks:

The following chart depicts main types of commercial banks in India.

Scheduled Banks and Non-scheduled Banks:

Commercial banks are classified in two broad categoriesscheduled banks and non-
scheduled banks.

Scheduled banks are those banks which are included in Second Schedule of Reserve
Bank of India. A scheduled bank must have a paid-up capital and reserves of at least Rs
5 lakh. RBI provides special facilities including credit to scheduled banks. Some of
important scheduled banks are State Bank of India and its subsidiary banks,
nationalised banks, foreign banks, etc.
Non-scheduled Banks:

The banks which are not included in Second Schedule of RBI are known as non-
scheduled banks. A non-scheduled bank has a paid-up capital and reserves of less than
Rs 5 lakh. Clearly, such banks are small banks and their field of operation is also

A passing reference to some other types of commercial banks will be informative.

Industrial Banks provide finance to industrial concerns by subscribing (buying) shares

and debentures of companies and also give long-term loans to acquire machinery,
plants, etc. Foreign Exchange Banks are commercial banks which are branches of
foreign banks and facilitate international financial transactions through buying and
selling of foreign bills.

Agricultural Banks finance agriculture and provide long-term loans for buying tractors
and installing tube-wells. Saving Banks mobilise small savings of the people in savings
account, e.g., Post office saving bank. Cooperative Banks are organised by the people
for their own collective benefits. They advance loans to their members at fair rate of

Significance of Commercial Banks:

Commercial banks play such an important role in the economic development of a

country that modern industrial economy cannot exist without them. They constitute
nerve centre of production, trade and industry of a country. In the words of Wick-sell,
Bank is the heart and central point of modern exchange economy.

The following points highlight the significance of commercial banks:

(i) They promote savings and accelerate the rate of capital formation.

(ii) They are source of finance and credit for trade and industry.

(iii) They promote balanced regional development by opening branches in backward

(iv) Bank credit enables entrepreneurs to innovate and invest which accelerates the
process of economic development.

(v) They help in promoting large-scale production and growth of priority sectors such as
agriculture, small-scale industry, retail trade and export.

(vi) They create credit in the sense that they are able to give more loans and advances
than the cash position of the depositors permits.

(vii)They help commerce and industry to expand their field of operation.

(viii) Thus, they make optimum utilisation of resources possible.

39.Quantity theory of money

In monetary economics, the quantity theory of money states that money supply has a direct,
proportional relationship with the price level. For example, if the currency in circulation increased,
there would be a proportional increase in the price of goods.[1]
What Is the Quantity Theory
of Money?
By Reem HeakalAAA |

Related Searches:

Supply Side Economics Fiscal Policy Keynesian Economics Inflation Adam Smith

The concept of the quantity theory of money (QTM) began in the 16th century. As
gold and silver inflows from the Americas into Europe were being minted into
coins, there was a resulting rise in inflation. This led economist Henry Thornton in
1802 to assume that more money equals more inflation and that an increase in
money supply does not necessarily mean an increase in economic output. Here
we look at the assumptions and calculations underlying the QTM, as well as its
relationship to monetarism and ways the theory has been challenged.

QTM in a Nutshell
The quantity theory of money states that there is a direct relationship between the
quantity of money in an economy and the level of prices of goods and services
sold. According to QTM, if the amount of money in an economy doubles, price
levels also double, causing inflation (the percentage rate at which the level of
prices is rising in an economy). The consumer therefore pays twice as much for
the same amount of the good or service.

Another way to understand this theory is to recognize that money is like any other
commodity: increases in its supply decrease marginal value (the buying capacity
of one unit of currency). So an increase in money supply causes prices to rise
(inflation) as they compensate for the decrease in money's marginal value.

The Theory's Calculations

In its simplest form, the theory is expressed as:
MV = PT (the Fisher Equation)

Each variable denotes the following:

M = Money Supply
V = Velocity of Circulation (the number of times money changes hands)
P = Average Price Level
T = Volume of Transactions of Goods and Services

The original theory was considered orthodox among 17th century classical
economists and was overhauled by 20th-century economists Irving Fisher, who
formulated the above equation, and Milton Friedman. (For more on this important
economist, see Free Market Maven: Milton Friedman.)

It is built on the principle of "equation of exchange":

Amount of Money x Velocity of

Circulation = Total Spending

Thus if an economy has US$3, and those $3 were spent five times in a month,
total spending for the month would be $15.

QTM Assumptions
QTM adds assumptions to the logic of the equation of exchange. In its most basic
form, the theory assumes that V (velocity of circulation) and T (volume of
transactions) are constant in the short term. These assumptions, however, have
been criticized, particularly the assumption that V is constant. The arguments
point out that the velocity of circulation depends on consumer and business
spending impulses, which cannot be constant.

The theory also assumes that the quantity of money, which is determined by
outside forces, is the main influence of economic activity in a society. A change
in money supply results in changes in price levels and/or a change in supply of
goods and services. It is primarily these changes in money stock that cause a
change in spending. And the velocity of circulation depends not on the amount of
money available or on the current price level but on changesin price levels.
Finally, the number of transactions (T) is determined by labor, capital, natural
resources (i.e. the factors of production), knowledge and organization. The theory
assumes an economy in equilibrium and at full employment.

Essentially, the theory's assumptions imply that the value of money is determined
by the amount of money available in an economy. An increase in money supply
results in a decrease in the value of money because an increase in money supply
causes a rise in inflation. As inflation rises, the purchasing power, or the value of
money, decreases. It therefore will cost more to buy the same quantity of goods
or services.

Money Supply, Inflation and Monetarism

As QTM says that quantity of money determines the value of money, it forms the
cornerstone of monetarism. (For more insight, see Monetarism: Printing Mone To
Control Inflation.)

Monetarists say that a rapid increase in money supply leads to a rapid increase in
inflation. Money growth that surpasses the growth of economic output results in
inflation as there is too much money behind too little production of goods and
services. In order to curb inflation, money growth must fall below growth in
economic output.

This premise leads to how monetary policy is administered. Monetarists believe

that money supply should be kept within an acceptable bandwidth so that levels
of inflation can be controlled. Thus, for the near term, most monetarists agree
that an increase in money supply can offer a quick-fix boost to a staggering
economy in need of increased production. In the long term, however, the effects
of monetary policy are still blurry.

Less orthodox monetarists, on the other hand, hold that an expanded money
supply will not have any effect on real economic activity (production, employment
levels, spending and so forth). But for most monetarists any anti-inflationary
policy will stem from the basic concept that there should be a gradual reduction in
the money supply. Monetarists believe that instead of governments continually
adjusting economic policies (i.e. government spending and taxes), it is better to
let non-inflationary policies (i.e. gradual reduction of money supply) lead an
economy to full employment.

QTM Re-Experienced
John Maynard Keynes challenged the theory in the 1930s, saying that increases
in money supply lead to a decrease in the velocity of circulation and that real
income, the flow of money to the factors of production, increased. Therefore,

velocity could change in response to changes in money supply. It was conceded

by many economists after him that Keynes' idea was accurate.

QTM, as it is rooted in monetarism, was very popular in the 1980s among some
major economies such as the United States and Great Britain under Ronald
Reagan and Margaret Thatcher respectively. At the time, leaders tried to apply
the principles of the theory to economies where money growth targets were set.
However, as time went on, many accepted that strict adherence to a controlled
money supply was not necessarily the cure-all for economic malaise.

Get Out of Debt Start Making Money

Want to get out of debt, get a mortgage and save for retirement? Investopedias
FREE Personal Finance newsletter shows you 7 Steps to Become Financially
Independent. Take control of your money and Click here to start managing your
finances like the pros.

39---What do you mean by the term credit creation

A bank differs from other financial institutions because it can create credit. Banks have the
ability to expand their demand deposits as a multiple of their cash reserves. This is because
of the fact that demand deposits of the banks serve as the principal medium of exchange,
and, in this way, the banks manage the payments system of the country.

In short, multiple expansion of deposits is called credit creation and the ability of the banks to
expand the deposits makes them unique and distinguish them from other non-bank financial
institutions. Demand deposits are an important constituent of money supply and the expansion of
demand deposits means expansion of money supply.
The whole structure of banking is based on credit. Credit means getting the purchasing
power (i.e., money) now by a promise to pay at some time in future.

In the words of Kent, "Credit may be defined as the right to receive payment or the obligation to
make payment on demand or at some future tune on account of an immediate transfer of goods." In
a sense, the words credit, debt and loan are synonymous; credit or loan is the liability of the debtor
and the asset of the bank. The word credit is derived from a Latin word 'credo', which means 'I

The creditor believes that the debtor will return the loan and so decides to give the loan. Advancing
credit or loan essentially depends upon the (a) confidence, (b) character, (c) capacity, (d) capital, and
(e) collateral of the debtor.

Bank credit means bank loans and advances. A bank keeps a certain proportion of its deposits as
minimum reserve for meeting the demand of the depositors and lends out the remaining excess
reserve to earn income. The bank loan is not paid directly to the borrower but is only credited hi his
account. Every bank loan creates an equivalent deposit in the bank. Thus, credit creation means
multiple expansions of bank deposits. The word 'creation' refers to the ability of the bank to expand
deposits as a multiple of its reserves.

In nutshell, credit creation refers to the unique power of the banks lo multiply loans and advances,
and hence deposits. With a little cash in hand, the banks can create additional purchasing power lo a
considerable degree. It is because of the multiple credits creating power that the commercial banks
have been aptly called the 'factories of credit' or 'manufactures of money'.

In the words of Newlyn. "Credit creation refers to the power of commercial banks to expand
secondary deposits either through the process of making loans or through investment in securities."

According to Halm, "The creation of derivative deposits is identical with what is commonly called the
creation of credit.

5 Major Differences between Returns to Scale and

Returns to a factor Proportions
5 Major Differences between Returns to Scale and Returns to
a factor Proportions are listed below:
Returns to a factor:

1. Only one factor varies while all the rest are fixed.
2. The factor-proportion varies as more and more of the units of the variable factor are employed to
increase output.

4. Returns to a factor or to variable proportions end up in negative returns.

3. It is a short-run phenomenon.

5. Returns to variable proportions are caused by indivisibility of certain fixed factors, specialisation of
certain variable factors, or sub-optimal factor proportions.

Returns to scale:

1. All or at least two factors vary.

2. Factor proportion called scale does not vary. Factors are increased in same proportion to increase

3. It is a long-run phenomenon.

4. Returns to scale end up in decreasing returns.

5. Returns to scale can be attributed to economies and diseconomies of scale caused by technical
and/or managerial indivisibilities, exhaustibility of natural and managerial resources, or depreciability
of certain factors.

Returns to scale
From Wikipedia, the free encyclopedia

In economics, returns to scale and economies of scale are related but different terms that
describe what happens as the scale of production increases in the long run, when allinput levels
including physical capital usage are variable (chosen by the firm). The term returns to scale arises
in the context of a firm's production function. It explains the behaviour of the rate of increase in
output (production) relative to the associated increase in the inputs (the factors of production) in the
long run. In the long run all factors of production are variable and subject to change due to a given
increase in size (scale).
The laws of returns to scale are a set of three interrelated and sequential laws: Law of Increasing
Returns to Scale, Law of Constant Returns to Scale, and Law of Diminishing returns to Scale. If
output increases by that same proportional change as all inputs change then there are constant
returns to scale (CRS). If output increases by less than that proportional change in inputs, there
are decreasing returns to scale (DRS). If output increases by more than that proportional change
in inputs, there are increasing returns to scale (IRS). A firm's production function could exhibit
different types of returns to scale in different ranges of output. Typically, there could be increasing
returns at relatively low output levels, decreasing returns at relatively high output levels, and
constant returns at one output level between those ranges.[citation needed]

In mainstream microeconomics, the returns to scale faced by a firm are purely technologically
imposed and are not influenced by economic decisions or by market conditions (i.e., conclusions
about returns to scale are derived from the specific mathematical structure of the production
function in isolation).

The Laws Of Returns to Scale

Long run is a period during which all factors of production can vary. Long run relationship between
inputs and output of a firm is explained by the Laws of returns to scale. The term returns to scale
arises in the context of a firm's Production Function.In the long run production function, all factors
are variable. Therefore in the long run output can be changed by changing all the factors of
production.A firm's production function could exhibit different types of returns to scale in different
ranges of output.Typically, there could be Increasing returns to scale,Constant returns to scale and
Diminishing returns to scale. In this section we will use the isoquants to analyse the input output
relationships under the condition that both the inputs (labour and Capital) are variable and their
quantity is changed proportionately and simultaneously.

Statement of Law

"Other things being equal in the long run, as the firm increases the quantities of all factors employed,
the output may rise either more than proportionately, less than proportionately or in exactly same
proportion of the change in quantities of inputs.


1. Returns are measured in physical terms.

2. All units of factors are homogeneous.
3. Techniques of production remains constant.
Stages of Laws of Returns to Scale

1. The Increasing Returns to Scale

2. The Constant Returns to Scale
3. The Diminishing Returns to Scale

Explanation of Different Stages of Laws of Returns to


1. The Increasing Returns to Scale: ===

There are increasing returns to scale when a given percentage increase in input leads to a greater
relative percentage increase in output.

It shows that output doubles itself even before the inputs can be doubled.In the following figure that
the units of labour are measured on X-axis and units of capital on Y axis. The scale line OS is drawn
which shows the expansion path of a firm. In this case the distance between every successive
isoquants becomes smaller and smaller i.e. OA > AB > BC.


In case of increasing returns to scale, the production function is homogeneous of degree greater
than one.

100 units (IQ1 at A) = 3L+ 3K
200 units (IQ2 at B) = 5L + 5K
300 units (IQ3 at C) = 6L + 6K

How to read example (1) : 100 units of output requires three units of labour and three units of capital.

Causes of Increasing Returns to Scale:

a.Internal economies of scale

b.Efficiency of labour and capital
c.Improvement in large scale operation
d.Division of labour and specialization
e.Use of better and sophisticated technology
f.Economy of organisation
g.External economies of scale

2.Constant Returns to Scale

There are constant returns to scale when a given percentage increase in input leads to an equal
percentage increase in output. It shows that if inputs are doubled then the output also gets doubled.
If inputs are trebled then the output also trebles



Proportionate Change in input

In the following figure, the units of labour are measured on X-axis and units of capital on Y-axis. OS
is the scale of operation line. In this case the distance between every successive isoquant remains
equal i.e. OL = LM = MN. It means if units of labour and capital are doubled, the output also doubles.
In case of constant returns to scale, production function is homogenous of degree one.

Example : 100 units (IQ1 at L) = 3L + 3K 200 units (IQ2 at M) = 6L + 6K 300 units (IQ3 at N) = 9L +


Causes of Constant Returns to Scale:

a)Internal economics of scale are equal to internal diseconomies of scale.

b)Balancing of external economics and diseconomies of scale

c)Factors of production are perfectly divisible substitutable, homogenous and their supply is perfectly
elastic at given prices.
3.Decreasing Returns to Scale

There are decreasing returns to scale when a given percentage increase in input leads to a smaller
percentage increase in output.

Symbolically :

Where: Proportionate change in output.

Following figure shows the decreasing returns, where, to get an equal increase in output, a larger
proportionate increase in both labour and capital are required. In case of decreasing returns to scale
the distance between every successive isoquant on expansion path becomes larger and larger, i.e.
OP < PQ < QR. In this case, production function is homogenous of degree less than one.


100 units (IQ, at P) = 3L + 3K 200 units (IQ2 at Q) = 7L + 7K 300 units (IQ3 at R) = 12L +12K


Causes of Decreasing Returns to Scale

a.Internal diseconomies of scale

b.External diseconomies of scale

c.Increase in business risk

d.Lack of entrepreneurial efficiency

e.Unhealtny management and organization

f.Imperfect factor substitutability

g.Transport bottlenecks and Marketing difficulties.

23-25 cost consept & cost curve

Costs and their Curves

Before we look at the cost curves in detail, we need to start with a few definitions.
Although we will be looking at the costs of a firm in terms of wages, raw materials, etc., economists
like to start with a more abstract term. What does an economist mean by the economic cost of
production? This is theopportunity cost of production. As you have probably read in more textbooks
than you care to remember, this is the value that could have been generated had the resources been
employed in their next best use. Remember that this concept of opportunity cost is useful when
dealing with production possibility frontiers.

It is also important that you understand the difference between fixed cost and variable costs. Fixed
costs are those that do not vary as output increases. Examples include rent, office costs and,
certainly in the short run, machinery.

Variable costs, surprise surprise, are costs that do vary as output increases. The best example is raw
materials. If a firm wants to make more chocolate, for example, it will need more cocoa beans and

Labour is also a variable cost, but some textbooks refer to it as semi-variable. Many firms have a
fairly permanent staff. If they need to increase output, the workers will be asked to do overtime. In a
sense, this is still variable, because the number of man-hours worked will still rise, but the actual
number of workers may not. Of course, if a firm is planning some serious expansion, the actual number
of workers employed will eventually rise, but employers are nervous about employing someone
permanently who may not be required in the long term. The cost of letting a permanent member of
staff go can be much higher than sacking a part-time or contract worker.

Total, marginal and average costs

As with total, marginal and average product in the last Learn-It, we first need to define total, average
and marginal cost.

Total cost (TC). This is the total cost to the firm of producing a given number of units. This can be
sub-divided. Total cost = total fixed costs + total variable costs (or TC = TFC + TVC). A cost is either
fixed or variable. There is no third group. If a cost is not fixed, then, by definition, it must vary with

Average cost (AC). This is the cost, on average, per unit of output produced. If a firm made 100 bars
of chocolate at a total cost of 10, then the cost, on average, per bar of chocolate produced, is 10p.
So, algebraically:

It also follows that average cost = average fixed cost + average variable cost (AC = AFC + AVC). This
is derived by simply dividing both sides of the total cost equation by Q. Average cost is often
called average total cost so as to distinguish it from AFC and AVC.
Marginal cost (MC). This is the additional cost incurred by a firm as a result of producing one
more unit of output. It is the extra cost at the margin (i.e. by producing the marginal unit of

How the cost curves are derived

It is important to understand why the cost curves look like they do. The concept of Diminishing
marginal Returns is the one from which we derive the cost curves. So the marginal cost and average
cost curves come from the product curves, which are, in turn, derived from thelaw of diminishing
marginal returns. The average variable cost curve comes from the product curves in exactly the
same way


Revenue: The Meaning and Concept of Revenue | Micro Economics

Read this article to learn about the meaning and concept of

revenue, micro economics!

Meaning of Revenue:
The amount of money that a producer receives in exchange for the sale
proceeds is known as revenue. For example, if a firm gets Rs. 16,000
from sale of 100 chairs, then the amount of Rs. 16,000 is known as

Revenue refers to the amount received by a firm from the sale of a

given quantity of a commodity in the market.

Revenue is a very important concept in economic analysis. It is

directly influenced by sales level, i.e., as sales increases, revenue also

Concept of Revenue:
The concept of revenue consists of three important terms; Total
Revenue, Average Revenue and Marginal Revenue.
Total Revenue (TR):

Total Revenue refers to total receipts from the sale of a given quantity
of a commodity. It is the total income of a firm. Total revenue is
obtained by multiplying the quantity of the commodity sold with the
price of the commodity.

Total Revenue = Quantity Price

For example, if a firm sells 10 chairs at a price of Rs. 160 per chair,
then the total revenue will be: 10 Chairs Rs. 160 = Rs 1,600

Average Revenue (AR):

Average revenue refers to revenue per unit of output sold. It is

obtained by dividing the total revenue by the number of units sold.

Average Revenue = Total Revenue/Quantity

For example, if total revenue from the sale of 10 chairs @ Rs. 160 per
chair is Rs. 1,600, then:

Average Revenue = Total Revenue/Quantity = 1,600/10 = Rs 160

AR and Price are the Same:

We know, AR is equal to per unit sale receipts and price is always per
unit. Since sellers receive revenue according to price, price and AR are
one and the same thing.

This can be explained as under:

TR = Quantity Price (1)

AR = TR/Quantity (2)

Putting the value of TR from equation (1) in equation (2), we get

AR = Quantity Price / Quantity

AR = Price

AR Curve and Demand Curve are the Same:

A buyers demand curve graphically represents the quantities

demanded by a buyer at various prices. In other words, it shows the
various levels of average revenue at which different quantities of the
good are sold by the seller. Therefore, in economics, it is customary to
refer AR curve as the Demand Curve of a firm.

Marginal Revenue (MR):

Marginal revenue is the additional revenue generated from the sale of

an additional unit of output. It is the change in TR from sale of one
more unit of a commodity

Let us understand this with the help of an example: If the total

revenue realised from sale of 10 chairs is Rs. 1,600 and that from sale
of 14 chairs is Rs. 2,200, then the marginal revenue will be:

MR = TR of 14 chairs TR of 10 chairs / 14 chairs -10 chairs = 600/4

= Rs. 150

TR is summation of MR:

Total Revenue can also be calculated as the sum of marginal revenues

of all the units sold.
31-33What is Market? Meaning, Types or Classification of Market

What is Market? Meaning

Usually, Market means a place where buyer and seller meets together in order to
carry on transactions of goods and services.

But in Economics, it may be a place, perhaps may not be. In Economics, market can
exist even without direct contact of buyer and seller. This fact can be explained with
the help of the following statement.

"Market refers to an arrangement, whereby buyers and sellers come

in contact with each other directly or indirectly, to buy or sell

Thus, above statement indicates that face to face contact of buyer and seller is not
necessary for market. E.g. In stock or share market, the buyer and seller can carry on
their transactions through internet. So internet, here forms an arrangement and such
arrangement also is included in the market.

Classification or Types of Market

The classification or types of market are depicted in the following chart.

Generally, the market is classified on the basis of:

1. Place,

2. Time and

3. Competition.

On the basis of Place, the market is classified into:

1. Local Market or Regional Market.

2. National Market or Countrywide Market.

3. International Market or Global Market.

On the basis of Time, the market is classified into:

1. Very Short Period Market.

2. Short Period Market.

3. Long Period Market.

4. Very Long Period Market.

On the basis of Competition, the market is classified into:

1. Perfectly Competitive Market Structure.

2. Imperfectly Competitive Market Structure.

Both these market structures widely differ from each other in respect of their features,
price, etc. Under imperfect competition, there are different forms of markets like
monopoly, duopoly, oligopoly and monopolistic competition.

1. A monopoly has only one or a single (mono) seller.

2. Duopoly has two (duo) sellers.

3. Oligopoly has little or fewer (oligo) number of sellers.

4. Monopolistic competition has many or several numbers of


The suffix poly has its origin from Greek word Polus which means many or more than

Market Structure: Meaning, Characteristics and Forms | Economics

by Smriti Chand Market

Market structure refers to the nature and degree of competition in

the market for goods and services. The structures of market both for
goods market and service (factor) market are determined by the
nature of competition prevailing in a particular market.

Meaning of Market:

Ordinarily, the term market refers to a particular place where goods

are purchased and sold. But, in economics, market is used in a wide
perspective. In economics, the term market does not mean a
particular place but the whole area where the buyers and sellers of a
product are spread.

This is because in the present age the sale and purchase of goods are
with the help of agents and samples. Hence, the sellers and buyers of a
particular commodity are spread over a large area. The transactions
for commodities may be also through letters, telegrams, telephones,
internet, etc. Thus, market in economics does not refer to a particular
market place but the entire region in which goods are bought and sold.
In these transactions, the price of a commodity is the same in the
whole market.

According to Prof. R. Chapman, The term market refers not

necessarily to a place but always to a commodity and the buyers and
sellers who are in direct competition with one another. In the words
of A.A. Cournot, Economists understand by the term market, not
any particular place in which things are bought and sold but the whole
of any region in which buyers and sellers are in such free intercourse
with one another that the price of the same goods tends to equality,
easily and quickly. Prof. Cournots definition is wider and appropriate
in which all the features of a market are found.

Contents :

1. Meaning of Market

2. Characteristics of Market

3. Market Structure

4. Forms of Market Structure

Characteristics of Market:

The essential features of a market are:

(1) An Area:

In economics, a market does not mean a particular place but the whole
region where sellers and buyers of a product ate spread. Modem
modes of communication and transport have made the market area for
a product very wide.

(2) One Commodity:

In economics, a market is not related to a place but to a particular


Hence, there are separate markets for various commodities. For

example, there are separate markets for clothes, grains, jewellery, etc.

(3) Buyers and Sellers:

The presence of buyers and sellers is necessary for the sale and
purchase of a product in the market. In the modem age, the presence
of buyers and sellers is not necessary in the market because they can
do transactions of goods through letters, telephones, business
representatives, internet, etc.

(4) Free Competition:

There should be free competition among buyers and sellers in the

market. This competition is in relation to the price determination of a
product among buyers and sellers.

(5) One Price:

The price of a product is the same in the market because of free

competition among buyers and sellers.

On the basis of above elements of a market, its general

definition may be as follows:
The market for a product refers to the whole region where buyers and
sellers of that product are spread and there is such free competition
that one price for the product prevails in the entire region.

Market Structure:


Market structure refers to the nature and degree of competition in the

market for goods and services. The structures of market both for goods
market and service (factor) market are determined by the nature of
competition prevailing in a particular market.


There are a number of determinants of market structure for a

particular good.

They are:

(1) The number and nature of sellers.

(2) The number and nature of buyers.

(3) The nature of the product.

(4) The conditions of entry into and exit from the market.

(5) Economies of scale.

They are discussed as under:

1. Number and Nature of Sellers:

The market structures are influenced by the number and nature of

sellers in the market. They range from large number of sellers in
perfect competition to a single seller in pure monopoly, to two sellers
in duopoly, to a few sellers in oligopoly, and to many sellers of
differentiated products.

2. Number and Nature of Buyers:

The market structures are also influenced by the number and nature of
buyers in the market. If there is a single buyer in the market, this is
buyers monopoly and is called monopsony market. Such markets exist
for local labour employed by one large employer. There may be two
buyers who act jointly in the market. This is called duopsony market.
They may also be a few organised buyers of a product.

This is known as oligopsony. Duopsony and oligopsony markets are

usually found for cash crops such as rice, sugarcane, etc. when local
factories purchase the entire crops for processing.

3. Nature of Product:

It is the nature of product that determines the market structure. If

there is product differentiation, products are close substitutes and the
market is characterised by monopolistic competition. On the other
hand, in case of no product differentiation, the market is characterised
by perfect competition. And if a product is completely different from
other products, it has no close substitutes and there is pure monopoly
in the market.

4. Entry and Exit Conditions:

The conditions for entry and exit of firms in a market depend upon
profitability or loss in a particular market. Profits in a market will
attract the entry of new firms and losses lead to the exit of weak firms
from the market. In a perfect competition market, there is freedom of
entry or exit of firms.

But in monopoly and oligopoly markets, there are barriers to entry of

new firms. Usually, governments have a monopoly in public utility
services like postal, air and road transport, water and power supply
services, etc. By granting exclusive franchises, entries of new supplies
are barred. In oligopoly markets, there are barriers to entry of firms
because of collusion, tacit agreements, cartels, etc. On the other hand,
there are no restrictions in entry and exit of firms in monopolistic
competition due to product differentiation.

5. Economies of Scale:

Firms that achieve large economies of scale in production grow large

in comparison to others in an industry. They tend to weed out the
other firms with the result that a few firms are left to compete with
each other. This leads to the emergency of oligopoly. If only one firm
attains economies of scale to such a large extent that it is able to meet
the entire market demand, there is monopoly.

Forms of Market Structure:

On the basis of competition, a market can be classified in the

following ways:

1. Perfect Competition

2. Monopoly

3. Duopoly

4. Oligopoly

5. Monopolistic Competition

1. Perfect Competition Market:

A perfectly competitive market is one in which the number of buyers

and sellers is very large, all engaged in buying and selling a
homogeneous product without any artificial restrictions and
possessing perfect knowledge of market at a time. In the words of A.
Koutsoyiannis, Perfect competition is a market structure
characterised by a complete absence of rivalry among the individual
firms. According to R.G. Lipsey, Perfect competition is a market
structure in which all firms in an industry are price- takers and in
which there is freedom of entry into, and exit from, industry.

Characteristics of Perfect Competition:

The following are the conditions for the existence of perfect


(1) Large Number of Buyers and Sellers:

The first condition is that the number of buyers and sellers must be so
large that none of them individually is in a position to influence the
price and output of the industry as a whole. The demand of individual
buyer relative to the total demand is so small that he cannot influence
the price of the product by his individual action.

Similarly, the supply of an individual seller is so small a fraction of the

total output that he cannot influence the price of the product by his
action alone. In other words, the individual seller is unable to
influence the price of the product by increasing or decreasing its

Rather, he adjusts his supply to the price of the product. He is output

adjuster. Thus no buyer or seller can alter the price by his individual
action. He has to accept the price for the product as fixed for the whole
industry. He is a price taker.

(2) Freedom of Entry or Exit of Firms:

The next condition is that the firms should be free to enter or leave the
industry. It implies that whenever the industry is earning excess
profits, attracted by these profits some new firms enter the industry.
In case of loss being sustained by the industry, some firms leave it.

(3) Homogeneous Product:

Each firm produces and sells a homogeneous product so that no buyer
has any preference for the product of any individual seller over others.
This is only possible if units of the same product produced by different
sellers are perfect substitutes. In other words, the cross elasticity of the
products of sellers is infinite.

No seller has an independent price policy. Commodities like salt,

wheat, cotton and coal are homogeneous in nature. He cannot raise
the price of his product. If he does so, his customers would leave him
and buy the product from other sellers at the ruling lower price.

The above two conditions between themselves make the average

revenue curve of the individual seller or firm perfectly elastic,
horizontal to the X-axis. It means that a firm can sell more or less at
the ruling market price but cannot influence the price as the product is
homogeneous and the number of sellers very large.

(4) Absence of Artificial Restrictions:

The next condition is that there is complete openness in buying and

selling of goods. Sellers are free to sell their goods to any buyers and
the buyers are free to buy from any sellers. In other words, there is no
discrimination on the part of buyers or sellers.

Moreover, prices are liable to change freely in response to demand-

supply conditions. There are no efforts on the part of the producers,
the government and other agencies to control the supply, demand or
price of the products. The movement of prices is unfettered.

(5) Profit Maximisation Goal:

Every firm has only one goal of maximising its profits.

(6) Perfect Mobility of Goods and Factors:

Another requirement of perfect competition is the perfect mobility of

goods and factors between industries. Goods are free to move to those
places where they can fetch the highest price. Factors can also move
from a low-paid to a high-paid industry.

(7) Perfect Knowledge of Market Conditions:

This condition implies a close contact between buyers and sellers.

Buyers and sellers possess complete knowledge about the prices at
which goods are being bought and sold, and of the prices at which
others are prepared to buy and sell. They have also perfect knowledge
of the place where the transactions are being carried on. Such perfect
knowledge of market conditions forces the sellers to sell their product
at the prevailing market price and the buyers to buy at that price.

(8) Absence of Transport Costs:

Another condition is that there are no transport costs in carrying of

product from one place to another. This condition is essential for the
existence of perfect competition which requires that a commodity
must have the same price everywhere at any time. If transport costs
are added to the price of the product, even a homogeneous commodity
will have different prices depending upon transport costs from the
place of supply.

(9) Absence of Selling Costs:

Under perfect competition, the costs of advertising, sales-promotion,

etc. do not arise because all firms produce a homogeneous product.

Perfect Competition vs Pure Competition:

Perfect competition is often distinguished from pure competition, but

they differ only in degree. The first five conditions relate to pure
competition while the remaining four conditions are also required for
the existence of perfect competition. According to Chamberlin, pure
competition means, competition unalloyed with monopoly elements,
whereas perfect competition involves perfection in many other
respects than in the absence of monopoly. The practical importance
of perfect competition is not much in the present times for few
markets are perfectly competitive except those for staple food products
and raw materials. That is why, Chamberlin says that perfect
competition is a rare phenomenon.

Though the real world does not fulfil the conditions of perfect
competition, yet perfect competition is studied for the simple reason
that it helps us in understanding the working of an economy, where
competitive behaviour leads to the best allocation of resources and the
most efficient organisation of production. A hypothetical model of a
perfectly competitive industry provides the basis for appraising the
actual working of economic institutions and organisations in any

2. Monopoly Market:

Monopoly is a market situation in which there is only one seller of a

product with barriers to entry of others. The product has no close
substitutes. The cross elasticity of demand with every other product is
very low. This means that no other firms produce a similar product.
According to D. Salvatore, Monopoly is the form of market
organisation in which there is a single firm selling a commodity for
which there are no close substitutes. Thus the monopoly firm is itself
an industry and the monopolist faces the industry demand curve.

The demand curve for his product is, therefore, relatively stable and
slopes downward to the right, given the tastes, and incomes of his
customers. It means that more of the product can be sold at a lower
price than at a higher price. He is a price-maker who can set the price
to his maximum advantage.

However, it does not mean that he can set both price and output. He
can do either of the two things. His price is determined by his demand
curve, once he selects his output level. Or, once he sets the price for his
product, his output is determined by what consumers will take at that
price. In any situation, the ultimate aim of the monopolist is to have
maximum profits.
Characteristics of Monopoly:

The main features of monopoly are as follows:

1. Under monopoly, there is one producer or seller of a particular

product and there is no difference between a firm and an industry.
Under monopoly a firm itself is an industry.

2. A monopoly may be individual proprietorship or partnership or

joint stock company or a cooperative society or a government

3. A monopolist has full control on the supply of a product. Hence, the

elasticity of demand for a monopolists product is zero.

4. There is no close substitute of a monopolists product in the market.

Hence, under monopoly, the cross elasticity of demand for a monopoly
product with some other good is very low.

5. There are restrictions on the entry of other firms in the area of

monopoly product.

6. A monopolist can influence the price of a product. He is a price-

maker, not a price-taker.

7. Pure monopoly is not found in the real world.

8. Monopolist cannot determine both the price and quantity of a

product simultaneously.

9. Monopolists demand curve slopes downwards to the right. That is

why, a monopolist can increase his sales only by decreasing the price
of his product and thereby maximise his profit. The marginal revenue
curve of a monopolist is below the average revenue curve and it falls
faster than the average revenue curve. This is because a monopolist
has to cut down the price of his product to sell an additional unit.
3. Duopoly:

Duopoly is a special case of the theory of oligopoly in which there are

only two sellers. Both the sellers are completely independent and no
agreement exists between them. Even though they are independent, a
change in the price and output of one will affect the other, and may set
a chain of reactions. A seller may, however, assume that his rival is
unaffected by what he does, in that case he takes only his own direct
influence on the price.

If, on the other hand, each seller takes into account the effect of his
policy on that of his rival and the reaction of the rival on himself again,
then he considers both the direct and the indirect influences upon the
price. Moreover, a rival sellers policy may remain unaltered either to
the amount offered for sale or to the price at which he offers his
product. Thus the duopoly problem can be considered as either
ignoring mutual dependence or recognising it.

4. Oligopoly:

Oligopoly is a market situation in which there are a few firms selling

homogeneous or differentiated products. It is difficult to pinpoint the
number of firms in competition among the few. With only a few firms
in the market, the action of one firm is likely to affect the others. An
oligopoly industry produces either a homogeneous product or
heterogeneous products.

The former is called pure or perfect oligopoly and the latter is called
imperfect or differentiated oligopoly. Pure oligopoly is found primarily
among producers of such industrial products as aluminium, cement,
copper, steel, zinc, etc. Imperfect oligopoly is found among producers
of such consumer goods as automobiles, cigarettes, soaps and
detergents, TVs, rubber tyres, refrigerators, typewriters, etc.
Characteristics of Oligopoly:

In addition to fewness of sellers, most oligopolistic

industries have several common characteristics which are
explained below:

(1) Interdependence:

There is recognised interdependence among the sellers in the

oligopolistic market. Each oligopolist firm knows that changes in its
price, advertising, product characteristics, etc. may lead to counter-
moves by rivals. When the sellers are a few, each produces a
considerable fraction of the total output of the industry and can have a
noticeable effect on market conditions.

He can reduce or increase the price for the whole oligopolist market by
selling more quantity or less and affect the profits of the other sellers.
It implies that each seller is aware of the price-moves of the other
sellers and their impact on his profit and of the influence of his price-
move on the actions of rivals.

Thus there is complete interdependence among the sellers with regard

to their price-output policies. Each seller has direct and ascertainable
influences upon every other seller in the industry. Thus, every move by
one seller leads to counter-moves by the others.

(2) Advertisement:

The main reason for this mutual interdependence in decision making

is that one producers fortunes are dependent on the policies and
fortunes of the other producers in the industry. It is for this reason
that oligopolist firms spend much on advertisement and customer

As pointed out by Prof. Baumol, Under oligopoly advertising can

become a life-and-death matter. For example, if all oligopolists
continue to spend a lot on advertising their products and one seller
does not match up with them he will find his customers gradually
going in for his rivals product. If, on the other hand, one oligopolist
advertises his product, others have to follow him to keep up their

(3) Competition:

This leads to another feature of the oligopolistic market, the presence

of competition. Since under oligopoly, there are a few sellers, a move
by one seller immediately affects the rivals. So each seller is always on
the alert and keeps a close watch over the moves of its rivals in order
to have a counter-move. This is true competition.

(4) Barriers to Entry of Firms:

As there is keen competition in an oligopolistic industry, there are no

barriers to entry into or exit from it. However, in the long run, there
are some types of barriers to entry which tend to restraint new firms
from entering the industry.

They may be:

(a) Economies of scale enjoyed by a few large firms; (b) control over
essential and specialised inputs; (c) high capital requirements due to
plant costs, advertising costs, etc. (d) exclusive patents and licenses;
and (e) the existence of unused capacity which makes the industry
unattractive. When entry is restricted or blocked by such natural and
artificial barriers, the oligopolistic industry can earn long-run super
normal profits.

(5) Lack of Uniformity:

Another feature of oligopoly market is the lack of uniformity in the size

of firms. Finns differ considerably in size. Some may be small, others
very large. Such a situation is asymmetrical. This is very common in
the American economy. A symmetrical situation with firms of a
uniform size is rare.
(6) Demand Curve:

It is not easy to trace the demand curve for the product of an

oligopolist. Since under oligopoly the exact behaviour pattern of a
producer cannot be ascertained with certainty, his demand curve
cannot be drawn accurately, and with definiteness. How does an
individual seller s demand curve look like in oligopoly is most
uncertain because a sellers price or output moves lead to
unpredictable reactions on price-output policies of his rivals, which
may have further repercussions on his price and output.

The chain of action reaction as a result of an initial change in price or

output, is all a guess-work. Thus a complex system of crossed
conjectures emerges as a result of the interdependence among the
rival oligopolists which is the main cause of the indeterminateness of
the demand curve.

If the oligopolist seller does not have a definite demand curve for his
product, then how does he affect his sales. Presumably, his sales
depend upon his current price and those of his rivals. However, a
number of conjectural demand curves can be imagined.

For example, in differentiated oligopoly where each seller fixes a

separate price for his product, a reduction in price by one seller may
lead to an equivalent, more, less or no price reduction by rival sellers.
In each case, a demand curve can be drawn by the seller within the
range of competitive and monopoly demand curves.

Leaving aside retaliatory price movements, the individual sellers

demand curve under oligopoly for both price cuts and increases is
neither more elastic than under perfect or monopolistic competition
nor less elastic than under monopoly. It may still be indefinite and

This situation is shown in Figure 1 where KD 1 is the elastic demand

curve and MD is the less elastic demand curve. The oligopolies
demand curve is the dotted kinked KPD. The reason is quite simple. If
a seller reduces the price of his product, his rivals also lower the prices
of their products so that he is not able to increase his sales.

So the demand curve for the individual sellers product will be less
elastic just below the present price P (where KD1and MD curves are
shown to intersect). On the other hand, when he raises the price of his
product, the other sellers will not follow him in order to earn larger
profits at the old price. So this individual seller will experience a sharp
fall in the demand for his product.

Thus his demand curve above the price P in the segment KP will be
highly elastic. Thus the imagined demand curve of an oligopolist has a
comer or kink at the current price P. Such a demand curve is much
more elastic for price increases than for price decreases.

(7) No Unique Pattern of Pricing Behaviour:

The rivalry arising from interdependence among the oligopolists leads

to two conflicting motives. Each wants to remain independent and to
get the maximum possible profit. Towards this end, they act and react
on the price-output movements of one another in a continuous
element of uncertainty.

On the other hand, again motivated by profit maximisation each seller

wishes to cooperate with his rivals to reduce or eliminate the element
of uncertainty. All rivals enter into a tacit or formal agreement with
regard to price-output changes. It leads to a sort of monopoly within

They may even recognise one seller as a leader at whose initiative all
the other sellers raise or lower the price. In this case, the individual
sellers demand curve is a part of the industry demand curve, having
the elasticity of the latter. Given these conflicting attitudes, it is not
possible to predict any unique pattern of pricing behaviour in
oligopoly markets.

5. Monopolistic Competition:

Monopolistic competition refers to a market situation where there are

many firms selling a differentiated product. There is competition
which is keen, though not perfect, among many firms making very
similar products. No firm can have any perceptible influence on the
price-output policies of the other sellers nor can it be influenced much
by their actions. Thus monopolistic competition refers to competition
among a large number of sellers producing close but not perfect
substitutes for each other.

Its Features:

The following are the main features of monopolistic


(1) Large Number of Sellers:

In monopolistic competition the number of sellers is large. They are

many and small enough but none controls a major portion of the
total output. No seller by changing its price-output policy can have any
perceptible effect on the sales of others and in turn be influenced by
them. Thus there is no recognised interdependence of the price-output
policies of the sellers and each seller pursues an independent course of

(2) Product Differentiation:

One of the most important features of the monopolistic competition is
differentiation. Product differentiation implies that products are
different in some ways from each other. They are heterogeneous rather
than homogeneous so that each firm has an absolute monopoly in the
production and sale of a differentiated product. There is, however,
slight difference between one product and other in the same category.

Products are close substitutes with a high cross-elasticity and not

perfect substitutes. Product differentiation may be based upon
certain characteristics of the products itself, such as exclusive patented
features; trade-marks; trade names; peculiarities of package or
container, if any; or singularity in quality, design, colour, or style. It
may also exist with respect to the conditions surrounding its sales.

(3) Freedom of Entry and Exit of Firms:

Another feature of monopolistic competition is the freedom of entry

and exit of firms. As firms are of small size and are capable of
producing close substitutes, they can leave or enter the industry or
group in the long run.

(4) Nature of Demand Curve:

Under monopolistic competition no single firm controls more than a

small portion of the total output of a product. No doubt there is an
element of differentiation nevertheless the products are close
substitutes. As a result, a reduction in its price will increase the sales
of the firm but it will have little effect on the price-output conditions of
other firms, each will lose only a few of its customers.

Likewise, an increase in its price will reduce its demand substantially

but each of its rivals will attract only a few of its customers. Therefore,
the demand curve (average revenue curve) of a firm under
monopolistic competition slopes downward to the right. It is elastic
but not perfectly elastic within a relevant range of prices of which he
can sell any amount.
(5) Independent Behaviour:

In monopolistic competition, every firm has independent policy. Since

the number of sellers is large, none controls a major portion of the
total output. No seller by changing its price-output policy can have any
perceptible effect on the sales of others and in turn be influenced by

(6) Product Groups:

There is no any industry under monopolistic competition but a

group of firms producing similar products. Each firm produces a
distinct product and is itself an industry. Chamberlin lumps together
firms producing very closely related products and calls them product
groups, such as cars, cigarettes, etc.

(7) Selling Costs:

Under monopolistic competition where the product is differentiated,

selling costs are essential to push up the sales. Besides, advertisement,
it includes expenses on salesman, allowances to sellers for window
displays, free service, free sampling, premium coupons and gifts, etc.

(8) Non-price Competition:

Under monopolistic competition, a firm increases sales and profits of

his product without a cut in the price. The monopolistic competitor
can change his product either by varying its quality, packing, etc. or by
changing promotional programmes.

The features of market structures are shown in Table 1.

28-30The Producers Equilibrium | Microeconomics

Read this article to learn about the producers equilibrium!

Image Curtsey:


Like consumer, a producer also aims to maximise his satisfaction. But

a producers satisfaction is maximised in terms of profit. So, this
article deals with determination of a level of output, which yields the
maximum profit. In order to clearly understand the concept of
producers equilibrium, it is necessary to understand the meaning of
Meaning of Profit:
Profit refers to the excess of receipts from the sale of goods over the
expenditure incurred on producing them.

The amount received from the sale of goods is known as revenue and
the expenditure on production of such goods is termed as cost. The
difference between revenue and cost is known as profit. For example,
if a firm sells goods for Rs. 10 crores after incurring an expenditure of
Rs. 7 crores, then profit will be Rs. 3 crores.

Producers Equilibrium:
Equilibrium refers to a state of rest when no change is required. A firm
(producer) is said to be in equilibrium when it has no inclination to
expand or to contract its output. This state either reflects maximum
profits or minimum losses.

There are two methods for determination of Producers


1. Total Revenue and Total Cost Approach (TR-TC Approach)

2. Marginal Revenue and Marginal Cost Approach (MR-MC Approach)

It must be noted that scope of syllabus is restricted to Producers

Equilibrium by MR- MC Approach. Still, for better understanding,
Producers Equilibrium by TR-TC approach is given.

Before we proceed further, we must be clear about one more point.

Producer can attain the equilibrium level under two different

(i) When Price remains Constant (It happens under Perfect

Competition). In this situation, firm has to accept the same price as
determined by the industry. It means, any quantity of a commodity
can be sold at that particular price.
(ii) When Price Falls with rise in output (It happens under Imperfect
Competition). In this situation, firm follows its own pricing policy.
However, it can increase sales only by reducing the price.

For detailed discussion on Perfect and Imperfect Competition, refer

Chapter 10. Let us now discuss determination of Producers
Equilibrium by both the methods under the two situations separately.

Total Revenue-Total Cost Approach (TR-TC Approach):

A firm attains the stage of equilibrium when it maximises its profits,
i.e. when he maximises the difference between TR and TC. After
reaching such a position, there will be no incentive for the producer to
increase or decrease the output and the producer will be said to be at

According to TR-TC approach, producers equilibrium refers to stage

of that output level at which the difference between TR and TC is
positively maximized and total profits fall as more units of output are
produced. So, two essential conditions for producers equilibrium are:

The difference between TR and TC is positively maximized;

Total profits fall after that level of output.

The first condition is an essential condition. But, it must be

supplemented with the second condition. So, both the conditions are
necessary to attain the producers equilibrium.

Producers Equilibrium (When Price remains Constant):

When price remains same at all output levels (like in case of perfect
competition), each producer aims to produce that level of output at
which he can earn maximum profits, i.e. when difference between TR
and TC is the maximum. Let us understand this with the help of Table
8.1, where market price is fixed at Rs. 10 per unit:
Table 8.1: Producers Equilibrium (When Price remains

Outp Pric Profit

ut e TR TC = TR-
(unit (Rs. (Rs. (Rs. TC
s) ) ) ) (Rs.) Remarks
0 10 0 5 -5 Profit rises
1 10 10 8 2 increase
2 10 20 15 5 in output
3 10 30 21 9
4 10 40 31 9 Equilibrium
Profit falls
5 10 50 42 8 with
increase in
6 10 60 54 6 output

According to Table 8.1, the maximum profit of Rs. 9 can be achieved

by producing either 3 units or 4 units. But, the producer will be at
equilibrium at 4 units of output because at this level, both the
conditions of producers equilibrium are satisfied:

1. Producer is earning maximum profit of Rs. 9;

2. Total profit falls to Rs. 8 after 4 units of output.

In Fig. 8.1, Producers equilibrium will be determined at P OQ level of

output at which the vertical distance between TR and TC curves is the
greatest. At this level of output, tangent to TC curve (at point G) is
parallel to TR curve and difference between both the curves
(represented by distance GH) is maximum.

At quantities smaller or larger than OQ, such as OQ1 or OQ2 units, the
tangent to TC curve would not be parallel to the TR curve. So, the
producer is at equilibrium at OQ units of output.

Producers Equilibrium (When Price Falls with rise in


When price falls with rise in output (like in case of imperfect

competition), each producer aims to produce that level of output at
which he can earn maximum profits, i.e. when difference between TR
and TC is the maximum. Let us understand this with the help of Table

Table 8.2: Producers Equilibrium (When Price Falls with

rise in output):

Outp Pric Profit

ut e TR TC = TR-
(unit (Rs. (Rs. (Rs. TC
s) ) ) ) (Rs.) Remarks
0 10 0 2 -2 Profit rises
1 9 9 5 4 increase
2 8 16 9 7 in output
3 7 21 11 10
4 6 24 14 10 Equilibrium
Profit falls
5 5 25 20 5 with
increase in
6 4 24 27 -3 output

As seen in Table 8.2, producer will be at equilibrium at 4 units of

output because at this level, both the conditions of producers
equilibrium are satisfied:

Producer is earning maximum profit of Rs. 10;

Total profits fall to Rs. 5 after 4 units of output.

In Fig. 8.2, producers equilibrium will be determined at OQ level of

output at which the vertical distance between TR and TC curves is the
greatest. At this level of output, tangent to TR curve (at point H) is
parallel to the tangent to TC curve (at point G) and difference between
both the curves (represented by distance GH) is maximum.

Marginal Revenue-Marginal Cost Approach (MR-MC

According to MR-MC approach, producers equilibrium refers to stage
of that output level at which:

1. MC = MR:

As long as MC is less than MR, it is profitable for the producer to go on

producing more because it adds to its profits. He stops producing
more only when MC becomes equal to MR.

2. MC is greater than MR after MC = MR output level:

When MC is greater than MR after equilibrium, it means producing

more will lead to decline in profits.

Both the conditions are needed for Producers Equilibrium:

1. MC = MR:

We know, MR is the addition to TR from sale of one more unit of

output and MC is addition to TC for increasing production by one unit.
Every producer aims to maximize the total profits. For this, a firm
compares its MR with its MC. Profits will increase as long as MR
exceeds MC and profits will fall if MR is less than MC.

So, equilibrium is not achieved when MC < MR as it is possible to add

to profits by producing more. Producer is also not in equilibrium when
MC > MR because benefit is less than the cost. It means, the firm will
be at equilibrium when MC MR.

2. MC is greater than MR after MC = MR output level:

MC = MR is a necessary condition, but not sufficient enough to ensure
equilibrium. It is because MC = MR may occur at more than one level
of output. However, out of these, only that output level is the
equilibrium output when MC becomes greater than MR after the

It is because if MC is greater than MR, then producing beyond MC =

MR output will reduce profits. On the other hand, if MC is less than
MR beyond MC = MR output, it is possible to add to profits by
producing more. So, first condition must be supplemented with the
second condition to attain the producers equilibrium.

Producers Equilibrium (When Price remains Constant):

When price remains constant, firms can sell any quantity of output at
the price fixed by the market. Price or AR remains same at all levels of
output. Also, the revenue from every additional unit (MR) is equal to
AR. It means, AR curve is same as MR curve. Producer aims to
produce that level of output at which MC is equal to MR and MC is
greater than MR after MC = MR output level.

Let us understand this with the help of Table 8.3, where market price
is fixed at Rs. 12 per unit:

Table 8.3: Producers Equilibrium (When Price remains


Outp Pric Profit

ut e TR TC MR = TR-
(unit (Rs. (Rs. (Rs. (Rs. MC TC
s) ) ) ) ) (Rs.) (Rs.)
1 12 12 13 12 13 -1
2 12 24 25 12 12 -1
3 12 36 34 12 9 2
4 12 48 42 12 8 6
5 12 60 54 12 12 6
6 12 72 68 12 14 4

According to Table 8.3, MC = MR condition is satisfied at both the

output levels of 2 units and 5 units. But the second condition, MC
becomes greater than MR is satisfied only at 5 units of output.
Therefore, Producers Equilibrium will be achieved at 5 units of
output. Let us now discuss determination of equilibrium with the help
of a diagram:

Producers Equilibrium is determined at OQ level of output

corresponding to point K as at this point: (i) MC = MR; and (ii) MC is
greater than MR after MC = MR output level. In Fig. 8.3, output is
shown on the X-axis and revenue and costs on the Y-axis. Both AR and
MR curves are straight line parallel to the X-axis. MC curve is U-
shaped. Producers equilibrium will be determined at OQ level of
output corresponding to point K because only at point K, the following
two conditions are met:

1. MC = MR; and

2. MC is greater than MR after MC = MR output level

Although MC = MR is also satisfied at point R, but it is not the point of
equilibrium as it satisfies only the first condition (i.e. MC = MR). So,
the producer will be at equilibrium at point K when both the
conditions are satisfied.

Relation between Price and MC at Equilibrium (When Price

remains Constant):

When price remains same at all levels of output, then Price (or AR) =
MR. As equilibrium is achieved when MC = MR, it means, price is
equal to MC at the equilibrium level. For, Gross Profits are Maximum
at Point of Producers Equilibrium, refer Power Booster Section.

Producers Equilibrium (When Price Falls with rise in


When there is no fixed price and price falls with rise in output, MR
curve slope downwards. Producer aims to produce that level of output
at which MC is equal to MR and MC curve cuts the MR curve from
below. Let us understand this with the help of Table 8.4:

Table 8.4: Producers Equilibrium (When Price Falls with

rise in output):

Outp Pric Profit

ut e TR TC MR = TR-
(unit (Rs. (Rs. (Rs. (Rs. MC TC
s) ) ) ) ) (Rs.) (Rs.)
1 8 8 6 8 6 2
2 7 14 11 6 5 3
3 6 18 15 4 4 3
4 5 20 20 2 .5 0
5 4 20 26 0 6 -6
According to Table 8.4, both the conditions of equilibrium are satisfied
at 3 units of output. MC is equal to MR and MC is greater than MR
when more output is produced after 3 units of output. So, Producers
Equilibrium will be achieved at 3 units of output. Let us understand
the determination of equilibrium with the help of a diagram:

Producers Equilibrium is determined at OM level of output

corresponding to point E as at this point: (i) MC = MR; and (ii) MC is
greater than MR after MC = MR output level.

In Fig. 8.4, output is shown on the X-axis and revenue and costs on
the Y-axis. Producers equilibrium will be determined at OM level of
output corresponding to point E because at this, the following two
conditions are met:

1. MC = MR; and

2. MC is greater than MR after MC = MR output level.

So, the producer is at equilibrium at OM units of output.

Relation between Price and MC at Equilibrium (When Price

Falls with rise in output):
When more output can be sold only by reducing the prices, then Price
(or AR) > MR. As equilibrium is achieved when MC = MR, it means,
price is more than MC at the equilibrium level.

Video Games

Price and output determination under perfect


Meaning of perfect competition

Perfect competition is wider concept than pure competition. Pure competition is said to be exist when following
conditions are fulfilled:

Large number of buyers and sellers: It is assumed that in pure competition market there should be a large number
of buyers and sellers. If it is so, the output of any single firm is only a small proportion of the total output and each
consumer buys small part of the total. Hence no individual purchaser can influence the market price by varying his
own demand and no single firm is in the position to affect the market price by varying its own output.

Homogenous product: The commodity produced by all firms should be identical in pure competition. Thus the
commodity produced by different firms are perfect substitutes. Hence the buyers are indifferent as to the firm from
which they purchase.

Perfect competition is wider term than pure competition. Besides the two conditions of pure competition mentioned
above several other conditions must be fulfilled to make it a perfect competition.

Free entry and exit: There should be no restrictions legal or other on the firms to entry and exit the industry. In this
situation all the firms can earn only normal profit. Because if the profit is more than the normal, new firms will enter
and extra profit will be reduced and if the profit is less than normal, some firms will leave the industry raising the
profits for the remaining firms. Hence the firms can earn normal profit in long run.

Perfect knowledge: Another assumption of perfect competition is that the purchasers and sellers should have
perfect knowledge about costs, price and quality. Due to this fact neither the seller can charge more than the ruling
price nor the purchaser are willing to pay more.

Free mobility of the resources: The mobility of resources is essential to the firms in order to adjust their supply to
demand. If the demand exceeds supply additional factors of production move into the industry and vice versa.

Price Determination
Before Marshall there was controversy among economists on whether the force of demand (i.e. marginal utility ) or
the force of supply (i.e. cost of production) is more important is determining price. Marshall gave equal importance to
both the demand and supply in determination of price. According to him, As both blades of a scissors are important
for cutting a cloth, so is both demand and supply essential for determination of price.

As we know that quantity demanded and quantity supplied vary with price , the equilibrium price is determined at the
point where quantity demanded and quantity supplied are equal. If the equality between quantity demanded and
quantity supplied doesnt hold for some price, buyers and sellers desire are inconsistent. In case of either quantity
demanded by the buyers is more than that offered by the sellers or or the quantity supplied by the sellers is greater
than the quantity demanded by the buyers the price will change so as to bring about equality between quantity
demanded and quantity supplied.

It is seen in the table that when price is Rs 3 per unit, quantity demanded and quantity supplied are equal at 12 unit.
When price is Rs 5 per unit, quantity demanded is 9 units and the amount offered at this price is 18 unit is greater
than demand and there will be the tendancy for the price to fall, because at the price Rs 5 some of the seller will be
unable to sell all the quantity they want to sale therefore they will reduce the price in order to attract the customers.
Similarly at price Rs 4 quantity demanded 10 units is less than the quantity supplied 16 units causes to fall in price.
Similarly at price Rs 1 quantity demanded 20 is greater than quantity supplied zero causes to increase in price. In the
other words, at this price the buyers who are willing to buy will find that quantity offered is not sufficient to satisfy
their wants. Hence those consumers who have not been able to satisfy their wants will induce to increase the price or
are willing to pay more for getting commodity. The process of price determination can be explained with the help of
following diagram:

In the figure above, the price has been measured along vertical axis and quantity along horizontal axis. DD is the
demand curve and SS is the supply curve. It is seen in the figure that at price OP quantity demanded is equal to the
quantity supplied. So OP is the equilibrium price. At price more than OP supply is greater than demand causes to fall
in the price. Similarly at price less than OP demand is greater than supply causes to rise in the price. Hence the
equilibrium price OP is determined by demand and supply both.

Short run equilibrium of the firm and industry:

Under perfect competition a firm takes price as given. In other words in perfect competition single firm and consumer
cannot influence the price by varying their supply and demand respectively. Hence price remains constant in perfect
competition. So the problem is to determine the output level to maximize profit.

We know that in short run total fixed cost incurred even if the output is nil or fixed cost remains same whatever be the
level of output. Hence average variable cost plays an important role in making decision whether to produce or not. If
the price falls below the minimum average variable cost then the firm will shut down in order to minimize losses. So
the minimum variable cost sets a limit to the price in short run.

As we know that firm will be in equilibrium when it is earning maximum profit. According to marginal cost and marginal
revenue approach a firm will make maximum profit when MR and MC are equal and MC cuts MR from below. The
short run equilibrium of the firm requires short run equality between demand and supply. This can be explained
clearly with the help of following diagram:

It is seen in the figure that the market price OP has been determined by the intersection point of the demand curve
(D) and supply curve(S). Hence at OP price the firm can sale any amount of output. As shown in the figure at OM
level of output both conditions of profit maximization or equilibrium of the firm are fulfilled. Hence the firm produces
OM amount of commodity and sales at OP price. The total revenue earned by the firm by producing OM amount of
output is represented by rectangle AOMB (price OA x quantity OM). And the total cost for producing OM amount of
output is represented by rectangle DOMC (average cost OD x quantity OM).Hence the firm earns abnormal profit
represented by the shaded rectangle ABCD( total revenue AOMB total cost DOMC).


If AC is tangent at equilibrium point then firm earns normal profit.

If the equilibrium point lies above to the AC curve then the firm earns abnormal profit.

If the equilibrium point lies below to the AC curve then the firm will be in losses.

Long run equilibrium of the firm and industry:

In long run no firm can make abnormal profit or losses under perfect competition. This is because abnormal
profit will attract new firms into the industry. Hence the supply of commodity increases leads to fall in the price and
abnormal profit will disappear. Similarly if there is losses some firms will leave the industry . So the supply of
commodity decreases and causes to increase the price and remaining firms can make normal profit. This can be
explained clearly with the help of following diagram:

It is seen in the figure that the market price OP has been determined by the intersection point of the demand curve
(D) and supply curve(S). Hence at OP price the firm can sell any amount of output. As we know that in long run no
firm can make abnormal profit. Hence equilibrium point of the firm lies at minimum level of average cost curve or
tangency point of LAC and average revenue curve as shown in the figure at point F. Hence profit maximizing level of
output is OM and long run equilibrium of the firm under perfect competition is at point F, where the conditions of profit
maximization are fulfilled. For example, it is seen in the figure that at point F, MC and MR are equal and MC cuts
MR from below. At point F, MC=MR=AR=P. So the firm earns normal profit only.

When this condition exists for all firms in the industry, new firms are not encouraged to enter nor existing firms are
pressured to leave the industry. So the industry as a whole will be in equilibrium.

Price and output determination under monopoly:

Concept of monopoly:

The monopoly is that market form in which a single producer controls the whole supply of single commodity which
has no close substitutes. Since there is only one firm under monopoly so the distinction between the firm and industry
disappears under the conditions of monopoly. The following conditions are necessary for pure monopoly:

Single seller : There should be only one seller or producer of a single commodity. Monopoly may be in the form sole
proprietorship or joint stock company.

Absence of close substitutes : There should not exist any close substitute of the commodity. If there are
substitutes, competition prevails and monopoly disappears.

Restriction on the entry of new firms : There should be restrictions on the entry of new firms. Hence the existing
firm has control over the supply of the product. Due to this fact the monopolist earns abnormal profit in both in the
short run as well as in the long run.

Short run equilibrium:

We know that under monopoly to sell more seller has to reduce the price. Hence the average revenue curve under
monopoly slopes downward. Since the average revenue curve is not horizontal straight line, MR curve will not
coincide with AR. In other words under monopoly the marginal revenue curve lies below the average revenue.

As we know that the equilibrium condition requires that MC curve must cut MR curve from below. The price and
output equilibrium of the monopolist can be easily understood from the following diagram:

The figure above represents equilibrium of the firm under monopoly. AR is the demand curve or average revenue
curve facing monopolist. MR is the marginal revenue curve lying below the AR. SAC and SMC are the average cost
and marginal cost curves. Until OM level of output, MR is greater than MC but beyond OM the marginal revenue is
less than the marginal cost. Therefore the monopolist will be in equilibrium at OM level of output and the profit is the
maximum. The price at which the OM level of output is sold in the market can be found by looking average revenue
curve (price) is OP. At the price OP and output level OM, the firm earns abnormal profit represented by the rectangle

Long run equilibrium:

There is no entry of new firms even in long run under monopoly. So abnormal profit is maintained even in long run.
Monopoly equilibrium in long run can be explained with the help of following diagr

The figure above represents equilibrium of the firm under monopoly in long run. As shown in the figure that the firm
will be in equilibrium when it produces OM amount of commodity at which MC = MR and MC cuts MR from below. At
OM level of output the monopolist earns abnormal profit represented by the rectangle ABTP. The price OP is
determined by the equilibrium level of output OQ.

Price and output determination under monopolistic competition

E. H. Chamberlin has developed this in 1933 because perfect competition and monopoly are imaginary
but monopolistic competition is real. Imperfect competition covers all situations where there is neither pure
competition nor pure monopoly. In other words it is the region of imperfect competition laying between these extreme
The average revenue curve slopes downward throughout its length but slopes downward at different rate in different
categories of imperfect competition. In case of nearly perfect competition AR slopes gently downward and it slopes
steeply where competition is strictly imperfect.

Features of monopolistic competition

1 Product differentiation

Goods are not homogeneous but similar and close substitute like different brands of toothpaste closeup pepsodent,
colgate etc (different in some quality , color, size or covering).

2 Large numbers of buyers and sellers

It is assumed that in monopolistic competition market there should be a large number of buyers and sellers. If it is so,
the output of any single firm is only a small proportion of the total output and each consumer buys small part of the
total. Hence no individual purchaser can not influence the market price by varying his own demand and no single firm
is in the position to affect the market price by varying its own output.

3 Non price competition

Price is determined by the entrepreneur himself.

4 goal of firm is to maximized profit

5 The price of factors of production is given.

6 Equilibrium of the firm does not occur at the lowest point of AC but left to lowest point.

7 free entry and exit of the firm.

Short run equilibrium:

The cost curves are u shaped indicates only one level of output can be produced at lowest cost. AR curve slopes
downward indicates more will be demanded at lower cost. In other words downward slope indicates more can be sold
by lowering the price because consumer of other product will be attracted. The higher the production differentiation
lower will be elasticity and lower the production differentiation higher will be elasticity. So in perfect competition the
product differentiation is zero elasticity of demand is perfectly elastic.

Long run equilibrium

AT equilibrium, MC=MR and AC=AR

Comparison between pure competition and monopoly

Perfect competition monopoly

Goal of firm is to maximization of profit Goal of firm is to maximization of profit

Product is homogeneous means goods There is no substitute

are perfect substitute

Large numbers of sellers Only one seller

There should be no restrictions legal or Restriction on the entry of new firms

other on the firms to entry and exit the

Cost curves are U shaped reflects only Cost curves are U shaped reflects only
one level of output can be produced at one level of output can be produced at
lowest cost lowest cost

Perfect knowledge is assumed Perfect knowledge is assumed

The decision of firm is to determine the Monopolist can determined price or

output level output not both

At equilibrium point MC = MR and MC At equilibrium point MC = MR and MC

cuts MR from below and price is cuts MR from below price is determined
determined at lowest point of AC at left to lowest point of AC. So in
monopoly output is lower and price will
be higher than perfect competition.

Comparison between perfect competition and monopolistic competition

Perfect competition Monopolistic competition

In long run equilibrium is defined at the In long run equilibrium is defined at the
tangency point of AC and AR where AC is tangency point of AC and AR at that
minimum so at that point AC =AR = MC point MC = MR and AC = AR = P where p
= MR = Price > MC so price will be higher and output
will be lower than perfect competition.

Firms earn normal profit Firms earn normal profit

Firm will be in equilibrium at left to the Firm will be in equilibrium at the lowest
lowest point of AC means producing point of AC means producing output
output less than optimal. optimal level means lowest AC.

Large numbers of sellers and buyers. Large numbers of sellers and buyers

Product homogeneous means good are Product differentiation means goods are
perfect substitute. close substitute like close up and colgate

Chapter 7.
Globalization and the
traditional role of
agriculture [124]

A Social Experiment Domestic Abuse Almost Went Wrong!

| | The Best Buzzing Stories Frying In One
Place (Buzzwok)

A key theme that emerges is that agriculture potentially benefits more proportionally than other
sectors but also suffers more from constraints to benefiting.

7.1 Introduction
Globalization refers to increases in the movement of finance, inputs, output, information, and science
across vast geographic areas. The gains from globalization increase net income in many places and
facilitate decreases in levels of poverty and may thereby increase levels of food security. However,
there is an implication of frictionless movement and perfect knowledge that understates the
requirements for benefiting from globalization.
These trends have been underway throughout history. As reflected in the previous chapter, they have
moved unusually rapidly in recent times because the cumulative breakthroughs in basic science have
allowed an extraordinary acceleration in the reduction of transfer costs. Real costs of information
transfer and shipment of goods have declined rapidly, while perishability and bulk have been
drastically reduced. Concurrently, increases in per capita income in many regions, and in the total
size of the market, have allowed scale economies to be achieved for myriad new products, most of
which involve value added processes that themselves require investment and improved technology.
These rapid changes have allowed a great increase in specialization in agriculture, and consequently
lower costs and rapid growth in trade.

Globalization can greatly enhance the role of agriculture as an engine of growth in low-income
countries by making it possible for agriculture to grow considerably faster than domestic
consumption. It also increases the potential for agriculture to increase food security through enlarged
multipliers to the massive, employment-intensive, non-tradable rural non-farm sector. With such
potential benefits, it is important to understand what is required for participation and to ensure that
the poor and hungry are lifted out of poverty and hunger by these processes.

7.2 Competing in the context of globalization

Three features characterize competing in the current globalization context:

Cost reductions in one place have immediate impacts in other places

Cost reduction and associated production increase constantly occurs in agriculture, and the pace is
accelerating, partly due to the forces of globalization. Thus, lower prices are often rapidly transmitted
to producers who have not participated in cost reduction. If they have not experienced cost reduction
in other endeavours either, they will experience a decline in income, eventually reverting to
minimum subsistence agriculture. All too many of the least-developed countries fall into this
category. They become poorer and more food insecure.

Cost reduction largely derives from technological advance

Cost-reducing technological change is the product of applied research, which increasingly depends
on constantly advancing basic research. Low-income countries that are not rapidly expanding and
improving their agricultural research capacity will not experience cost reductions and hence as others
reduce costs, and prices decline, incomes of the non-innovators will decline. Nowhere is this more
dramatic than in Africa, which has suffered from increasingly efficient production of first oil palm,
then cocoa, and now coffee from Asian countries that have been spending on research. Benefiting
from research is now far more complex than a few decades ago.

Basic research is moving far faster than ever before, constantly changing the context for applied
research. Private firms are responsible for a much larger absolute and relative share of agricultural
research than in the past. To benefit from modern biological science, complex relations between low-
income and high-income countries must be developed and even more complex relations between
private sector and public sector research. The first requisite for benefiting from research externalities
is a strong national research system. Rate of return analysis shows that all low-income countries are
vastly under-investing in applied agricultural research, particularly Africa. For low-income countries,
the role of the Consultative Group on International Agricultural Research (CGIAR) should become
far more important than in the past as a link to basic research, private sector research and high-
income countries.

Well operating markets in low-income countries are concentrated in major cities with reasonably
good physical infrastructure and hence at least moderate transaction costs. Undertaking international
trade is constantly decreasing in cost. Thus major urban markets in low-income countries are
increasingly open to foreign competition. Agricultural production in these countries takes place in
rural areas that are frequently deficit in physical infrastructure. Hence foreign sources of competition
may face low transport costs while domestic producers in low-income countries may face high
transport costs. Such costs are reduced by investment in physical infrastructure - most notably roads,
but also communications. However, improved infrastructure also facilitates the movement of
imported goods further into the rural economy, posing the threat of increased competition to local

Globalization has greatly increased the returns to roads and consequently radical to reductions in
costs. Rural roads in low-wage, low-income countries can be built with over half the cost in labour
and roughly half the cost represented by the food consumed by labour from their wages.

WTO rules constrain the extent to which countries can protect themselves

Created to facilitate the processes of globalization, the WTO works to reduce trade barriers and to
enforce agreed rules. However, the protectionist measures of the past are being allowed to continue
in high-income countries, whilst many low-income countries are opening their borders to, often
subsidized, imports.

7.3 The commodity composition of agriculture

Globalization has allowed agricultural production to grow much faster than in the past. A few
decades ago fast growth was somewhat over 3 percent per year. Now it is 4 to 6 percent . However,

these higher rates of growth involve a substantial change in its composition. The bulk of growth
initially came from basic food staples when the scope for export markets is limited, whereas there is
now a swing towards much higher value commodities. Explosive growth in income of high-income
countries means that large aggregates of production can now occur in what were previously small
niche markets. High quality coffee and tea are examples. The market for horticulture exports has also
grown immensely and can continue to grow.

As exports of high-value agricultural commodities increase and the multipliers to per capita income
develop, domestic demand for high-value livestock and horticulture will increase rapidly . Thus,
even in quite low-income countries, around half the increments to agricultural production will be in
high value horticulture and livestock for both export and domestic use. As a result, the role of cereal
production will become relatively less important.

As the production mix moves more towards export crops and high-value crops and livestock, the rate
of return to investments that reduce transaction costs will increase rapidly. The same is true for
investments in all the value-added enterprises. There is however a caveat on value added. Much of
such activity is through capital-intensive processes. There are also complexities in marketing. Both
will give comparative advantage to high-income countries. Low-income countries need to pay
attention to comparative advantage at every step in the chain from producer to consumer and should
not attempt components in which they lack a comparative advantage.

Cereals play an important role in food security in a global economy. The cost of shipping is
declining. Two forces in developing countries may lead to increased cereal imports. First,
globalization and specialization may lead to an increase in the area planted to high-value
commodities and potentially result in a decline in the area planted to cereals if either increased
intensity of production (i.e. double cropping) or extensification are not possible. Second, any shift of
income distribution towards the low-income, food insecure, will shift the demand schedule upwards.
Thus, low-income countries may be beneficiaries of declining cereal prices, even while they lose
from declining prices of other agricultural commodities.

7.4 Converting the benefits of globalization into food security

A major element in ensuring food security is increased incomes of poor people. The marginal
propensity of the poor to spend on food is high. The primary means by which low-income people
increase their incomes and hence their food security is through increased employment.

It is agricultural growth that reduces poverty , and agricultures impact is dependent on growth rates

that are considerably higher than population growth rates. The latter are indirect, working through
their impact on the demand for rural non-tradables that occupy a high proportion of the total labour
force and the bulk of the poor, food insecure .

The great majority of persons below the poverty line work in the rural non-farm sector. They include
many with a small tract of land that is insufficient to provide minimum subsistence. The rural non-
farm sector uses very little capital and hence is highly employment-intensive. It produces goods and
services that are dominantly non-tradable, that is they are dependent on local sources of demand.
Agricultural growth is the underlying source of that demand growth.

The agricultural demand shows strong growth multipliers since the rural non-farm sector also tends
to spend substantially on itself. This sector is highly elastic in supply, as would be expected of a
labour-intensive sector in a low-wage economy. The supply of rural non-tradables is highly elastic,
mainly because labour is the primary input and labour is elastic in supply as long as incomes are low
or underemployment is endemic. It is demand that constrains growth of the sector [129]
and that demand
comes from high agricultural growth rates.

That the impact of agriculture on poverty is indirect is consistent with the three or four year lag noted
before the full impact on poverty. That it works through the rural non-farm consumer-goods sector is
consistent with the finding that agriculture has little impact on poverty decline when land distribution
is highly unequal- usually associated with absentee landlords who have quite different consumption
patterns from those of peasant farmers.

For a major effect on employment, agriculture must grow substantially faster than population growth.
If it is to grow at the 4 to 6 percent rates required for achieving employment levels essential to food
security, then major components of agriculture must be exported. This will include the traditional
bulk exports such as cotton, coffee, tea, oil palm, and non-traditional exports including horticulture.
Globalization requires constant reduction in costs through research and its application as well as
constantly declining transaction costs through constantly increasing investment in rural
infrastructure. Without these a nation cannot compete: it is no accident that it is African nations that
suffer the most from declining commodity prices.

Below, the urgent requirements for low-income countries to benefit from globalization are presented.

Opening the economy to trade and market forces

The benefits of globalization flow from trade. Exports require imports, but trade restrictions tend to
drive up the cost of exports through higher costs of vital inputs and technology. Comparative
advantage needs to be seen for each component of a supply chain, not just for the final product.
Customs inefficiencies and corruption and a myriad other bureaucratic constraints are just as stifling
as tariffs and all need to be dealt with. However, opening to global market forces does little good if
costs are not being constantly reduced. Put differently, if the result of global forces interacting with
domestic investment and policy is to leave comparative advantage with subsistence production, no
amount of opening of markets will help.

Investing in agricultural research and dissemination

Low-income countries need to invest far more than at present in agricultural research and technology
dissemination. Without such investment, opening markets will do little good for agriculture and
hence for poverty reduction and food security. Identifying supporting mechanisms such as research
and training to minimise the exclusion of small resource poor farmers from value chains is also

Investing in rural infrastructure

Given the deplorable state of rural infrastructure in low-income countries, massive investments are
needed Investment in other economic risk reduction services such as insurance, irrigation, storage are
also likely to be required. Lack of such investment gradually shifts comparative advantage back
towards subsistence production at very low-income and little multiplier to the rural non-farm sector.
Winters notes that the transaction costs of trade with remote villages are often so great that it can

be cheaper for grain mills to buy from distant commercial growers than from small farmers located in
the region. However, improved infrastructure also lowers the final cost of imports in the producing

Facilitating private sector activity

All too often forgotten in these days of removing public sector constraints is the role that the public
sector plays in conjunction with the private sector, especially in exports. It is not enough to remove
bureaucratic constraints. Private sector investors in low-income countries tend to search for quick
turnover, particularly in trade. Initially, governments have to play a role in assisting the private sector
by participating in the costs of market analysis, assisting in the development of trade associations that
can diagnose needs, developing and enforcing grades and standards, meeting health regulations of
high-income importers, diagnosing special niche markets and carrying out analysis of constraints. In
the case of most low-income countries, such efforts are sometimes financed by foreign aid programs,
in a sense acting as public sector. Such efforts need to facilitate private sector action and gradually
low-income countries need to play that role themselves, rather than relying on foreign aid.

7.5 High-income country assistance in the context of globalization

High-income countries must play a major role in ensuring access to the best of modern science to
low-income countries. That calls for greatly expanded support of the CGIAR system and prodding
the system into playing a lead role in linking advanced biological science in high-income countries
with the needs of low-income countries, as well as bringing private sector research to low-income
countries and engendering cooperation.

High-income countries must also open their markets to low-income countries, particularly for high-
value crops. They should work with low-income countries in meeting phytosanitary rules and other
obstacles to trade. They must also ensure that farm income transfers do not depress world prices.
High-income countries must see that their measures to transfer incomes to their farmers do not result
in downward pressure on world prices and reduction in markets for low-income countries. Delinking
payments to farmers from prices is not sufficient, although it is a necessary condition. Payments to
farmers keep resources producing that would otherwise be withdrawn serve to depress prices.
Withdrawing land from production as part of payments and making payments that encourage lower
yields per hectare and per animal, would also help meet environmental objectives.

Lower cotton prices are a disaster for low-income cotton producers and lower vegetable oil prices are
similarly a strong negative factor. Reduced livestock prices are a particularly onerous burden on
farmers of low-income countries with little mitigating benefit. The Doha Round should be used to
obtain agreement from high-income countries to reduce support payments to farmers. This might roll
back some of the recent excesses.
While production-increasing policies for cereals hurt some countries, they in general benefit the food
insecure. These people are almost always net purchasers of cereals, so lower prices are helpful to
them. Low-income countries are increasingly importers of cereals, and will be more so as the area
devoted to high-value commodities is expanded. Thus, cereals are a special case, and as explained
below could be used in the context of building rural public works.

High-income countries should provide financial support for a massive programme of rural public
works. Calculations for Rwanda show that in a context of expanding rural employment (by 14
percent) and domestic agricultural production to meet major rural infrastructure needs, demand for
basic food staples would expand 9 percent more than supply. That would bring about a roughly 30
percent increase in domestic prices of basic food staples, which are largely non-tradable in Rwanda,
because of quality and transaction costs. This would be a disaster for poor people. Thus, a massive
rural public works programme would require imports of cereals roughly equal to 9 percent of
domestic basic food staples production. Such a programme on an Africa-wide basis would absorb the
bulk of excess production of cereals in the high-income countries. It follows that a massive food-aid
programme in the context of rural infrastructure development would be an important contribution of
high-income countries, particularly in the context of their domestic farm-support programmes.

7.6 Conclusion
Globalization, in the sense of rapid transmission of the impact of technology to all areas of the globe
with highly developed infrastructure, will continue to accelerate. Low-income countries that do not
spend heavily on research and technology dissemination and do not upgrade their rural infrastructure
and reduce transaction costs will experience continually declining prices for agricultural
commodities, but without offsetting decreases in costs of production.

In contrast, where costs are reduced by research and improved infrastructure, agriculture can attain
growth rates of at least 50 percent higher than in the past. That would have powerful multipliers to
the rural non-farm sector, thereby reducing poverty, increasing employment, and increasing food

High-income countries can assist this process though continuing to open trade in agricultural
commodities; preventing domestic farm support programmes from dumping commodities on world
markets; and, in the case of cereals, massively increasing demand through financing rural public
works programmes to reduce transaction costs in rural areas and bring them more fully into the
global market. Low-income countries, especially in Africa, must redirect public expenditure to
agricultural production, especially research and rural infrastructure. They should reduce constraints
to trade, including over valued exchange rates, and consider cutting customs barriers.

This chapter is based on a paper by John Mellor, The Impacts of Globalisation on the Role of

Agriculture presented at the Expert Consultation on Trade and Food Security: Conceptualizing the
Linkages. 11-12 July 2002, Rome.
Mellor, J. 1992. Agriculture on the Road to Industrialization, Johns Hopkins University Press,
Mellor. J. 1992. op cit.
Ravallion, M. & Datt, G. 1996. How Important to Indias poor is the sectoral composition of economic
growth, The World Bank Economic Review, vol.10, no.1; Timmer, C.P. 1997. How well do the poor
connect to the growth process? CAER Discussion Paper No. 178, Harvard Institute for International
Development, Cambridge, December.
Mellor, J. W. 2002. Productivity increasing rural public works - an interim approach to poverty
reduction in Rwanda, Abt Associates, Inc, Bethesda; Mellor, J. W. 2001. Rapid Employment Growth and
Poverty Reduction: Sectoral Policies in Rwanda, Abt Associates, Bethesda.; Mellor, J. W. & Ranade, C.
2002. Modeling Egyptian employment with a three sector model, agriculture, non-tradables, and urban
tradables, Abt Associates, Mimeo, Bethesda.
EQI. 2002. A study of SMEs in Rural Egypt published by Abt Associates, Bethesda; Mead, DC. and
Liedholm, C. 1988. The dynamics of micro and small enterprises in developing countries. World
Development, Vol. 26, no. 1. pp. 61-74
Winters, L. A. 2000. Trade liberalisation and poverty. Brighton: University of Sussex.

Ads by OffersWizard

Ads by OffersWizardAd Options

Ads by OffersWizard
You May Like

You should check this out

This Is What a Mothers Body Really Looks Like
Without Airbrushing! Continued....

The Most Terrifying Yet Bizarre Ancient Grave Yard With COFFINS Nailed...


Stunning Nude Photos Reveal What Women

REALLY Look Like After Giving Birth....

12 Best Cities For LGBT Members, Excluding New

York And San Francisco |...
You Definitely Do Not Want To See These Kind Of Pictures In A Wedding!...


You should check this out

Ads By OffersWizard

Related Searches

Organic Food Information

Agricultural Industry

Organic Agriculture

Food Security

World Food Programme

World Food Crisis

Agricultural Information

Forestry Jobs
Dolphin Deals