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( 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
efficiently.

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.

PRODUCTION POSSIBILITIES CURVE:

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
BLUE PLACIDOLA
[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.

but it is of equal and significant importance in our day-to-day decisions. although. Utility: Utility is the capacity of a commodity through which human wants are satisfied.law of Diminishing Marginal Utility . . The first apple gives him 20 utils (units for measuring utility). assumptions we make in the law of diminishing marginal utility and the exceptions where the law of diminishing marginal utility does not apply. provided other things remaining the same. Explanation for the Law of Diminishing Marginal Utility: We can briefly explain Marshall’s theory with the help of an example. you will find the definition of the law of diminishing marginal utility. According to his definition of the law of diminishing marginal utility.. The law of diminishing marginal utility is an important concept to understand. Law of Diminishing Marginal Utility: The law of diminishing marginal utility is comprehensively explained by Alfred Marshall.Detailed Explanation Note: There are two laws of utility that are often discussed together: law of diminishing marginal utility and the law of equi-marginal utility. We will first start with the basic definition of ‘Utility’.” Utils: 'Utils' is considered as the measurable 'unit' of utility. the following happens: “During the course of consumption. In this article. its detailed explanation with the help of a schedule and diagram. the total utility increases. It basically falls in the category of Microeconomics. every successive unit gives utility with a diminishing rate. This article explains the law of diminishing marginal utility.12…. as more and more units of a commodity are used. Assume that a consumer consumes 6 apples one after another.

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
zero.

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.
 Consumer’s 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
accurately.

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:

 Collection of rare objects.  Desire for knowledge. 7. Gossen. 4. The marginal utility of money is constant. Consumer has perfect knowledge of utility obtained from goods. The law of equi marginal utility is an extension of thelaw of diminishing marginal utility. Consumer is normal person so he tries to seek maximum satisfaction. Definition: "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". A consumer has number of wants. There is no change in the prices of the goods. He tries to spend limited income on different things in such a way that marginal utility of all things is equal. The goods have substitutes. 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. It is also known as law of maximum satisfaction or law of substitution or Gossen's second law. H. The income of consumer is fixed. Consumer has many wants. Assumptions of the Law of Equi Marginal Utility: 1. When he buys several things with given money income he equalizes marginal utilities of all such things. He should purchase such amount of each commodity that the last unit of money spend on each item provides same marginal utility. 2. 3. 5. Explanation With Schedule and Diagram: . 8. It is clear that consumer can get maximum utility from the expenditure of his limited income.  Desire for money. 13…Law of Equi Marginal Utility: The law of equi marginal utility was presented in 19th century by an Australian economists H. 6. The utility is measurable in cardinal terms.  Use of liquor or wine.

$5 on apples and $1 on bananas. 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. Suppose consumer has six dollars that he wants to spend on apples and bananas in order to obtain maximum total utility. The total utility he can get is: [(10+9+8+7+6) + (8)] = 48. This way the total utility is: [(10+9+8+7) + (8+7)] = 49. The total utility he can get is: [(10+9) + (8+7+6+5)] = 45. Total total utility for consumer is 49 utils that is the highest obtainable with expenditure of $4 on apples and $2 on bananas. 5. The total utility he can get is: [(10) + (8+7+6+5+4)] = 40.e 7 = 7 is also satisfied. 3. $1 on apples and $5 on bananas. Any other allocation of the last dollar shall give less total utility to the consumer. 4. Here the condition MU of apple = MU of banana i. $2 on apples and $4 on bananas. $3 on apples and $3 on bananas. $4 on apples and $2 on bananas. 2.The law of substitution can be explained with the help of an example. The total utility he can get is: [(10+9+8) + (8+7+6)] = 48. The same information can be used for graphical presentation of this law: .

The does not hold well in case of very low income. The consumer is unable to divide the goods to adjust units of utility derived from consumption of goods. 4. The consumer is unable to calculate utility of different commodities. which provides low utility due to non availability of goods having high utility. It does not work when there are frequent prices changes. 9. The law is not applicable in case of knowledge. marriages and deaths. There are certain lazy consumers. 2. 6. 8. It is psychological concept. The law fails when goods of choice are not available. Changing price levels create confusion in the minds of consumers. The calculation of marginal utility of durable goods is impossible. 7. Different books provide variety of knowledge and satisfaction.The diagram shows that consumer has income of six dollars. The law does not hold well in case fashion and customs. The law is not applicable in case of indivisible goods. It is not possible to express it into quantitative form. The people like to spend money on birthdays. He wants to spend this money on apples and bananas in such a way that there is maximum satisfaction to the consumer. The law is not applicable in case of durable goods. The consumer is bound to use commodity. Reading of books provides more satisfaction and knowledge to the scholar. There is no measurement of utility. . They go on consuming goods with comparing utility. 3. The maximization of utility is not possible due to low income. They do not care for maximum utility. 5. Limitations: 1. The law fails to operate in case of laziness of consumers.

He wishes to get maximum output and profit. Importance: 1. He will substitute saving and spending till marginal utility of a dollar spent and a dollar saved are equal. import and export. He will substitute one factor for another until marginal productivity of all factors is equal to prices of their services. There is maximum benefit from exchange of commodities. 6. This is called the law of satisfaction because we substitute more useful goods to less useful goods. The law of equi marginal utility is helpful in the field of production. The law is useful for workers in allocating the time between work and rest. The people like to exchange a commodity having low utility with a commodity having high utility. he can save more and spend less. 2. He can feel that a dollar saved has greater utility than a dollar spent. The does not work due to unlimited resources. The government can spend its revenue to get maximum social advantage. which is less scarce. He tries to equalize weighted marginal utility of all the things. The law tells us to use substitute commodity. The law is used in the field of exchange. The law is helpful in exchange of wealth. 4. There may be unlimited resources. The law is applicable in consumption. Due to scarcity of commodity its prices go up. 5. 8. They can compare the marginal utility of work and the marginal utility of rest. The law is applicable in public finance. An entrepreneur can pay factors of production equal to marginal product measured in money terms. He uses limited resources to purchase production factors. He tries to equalize marginal utility of all factors. The result is that the price of commodity comes down. The consumer can make choice between present wants and future wants. There is no need to change the direction of expenditure from one item to another when there are gifts of nature. 10. The marginal utility of each dollar spent in one sector must be equal to marginal utility derived from all other sectors. Spent in each direction is the same”. They can decide working hours and rest hours. 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 . trade. STATEMENT OR DEFINITION OF LAW: 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. The law is helpful in prices. 3. National income is distributed among factors of production according to this law. 7. The law holds well in case of saving and spending. A rational consumer tries to get maximum satisfaction when he spends his limited resources on various things. The producer has limited resources.

But in the busy and routine life we are not capable to do so that who is rational and who is irrational. Rationality: Every consumer should be rational in the purchase of goods. Indivisibility of Goods: Sometimes the goods are not divisible to small units. So MU cannot be calculated and law is not applicable.marginal utilities are equalized. the maximum satisfaction is attained. No Rational Calculation: The law involves rational calculations. . ASSUMPTIONS: Following are the assumptions of the law. through the process of substitution. So. Substitution of Goods: It is assumed that goods are naturally substitutes of each other. It is assumed that marginal utility of money remains constant but the law of DMU applies to money equally. His aim should be to maximize the total utility and nothing else. Consumer’s Ignorance: The consumer may not aware of the goods which are more useful than the goods which they are going to purchase. Independent Utilities: The marginal utilities of different commodities should be independent of each other and diminishes with more and more purchase. they cannot substitute more useful goods to the less useful goods and hence the law is not applicable to them. Wrong Assumptions: It assumed that utilities are measurable but in actual utility cannot be calculated because it is a state of mind. CRITICIZM OR LIMITATIONS: Following are the limitations of the law. The result of substitution will be the MU of one commodity will fall and that of another commodity will rise. Divisibility of Goods: The law is based on the assumption that goods are divisible in small units. 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. Awareness of Market: It is assumed that consumer has much awareness about the market. PRACTICAL IMPORTANCE:  This law is applied to all problems of scarce (limited) resource against unlimited wants.

We try to get as much satisfaction as we can. Here we are confronted with the basic conflict between preferences and the prices of the commodities consumer wants to consume. CONCLUSION: Thus the law of substation applies in all branches of economic theories. This law plays an important role in the theory of distribution and exchange. 9. CREATE CONSUMER'S EQUILIBRIUM 14. How to Derive Consumer's Equilibrium Through the Technique of Indifference Curve and Budget Line?  How Do Income Effect. All consumers strive to maximize their utility. The consumer’s 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. the means of achieving the goal is not clear. With a given amount of money income to spent. Although the goal of the consumer is maximization of satisfaction. we cannot attain the highest satisfaction but have to settle for less.  It extends over the field of the theory of production. Higher indifference curve not only gives higher satisfaction but also are more expensive. Substitution Effect and Price Effect Influence Consumer's Equilibrium?  The Hicksian Method and The Slutskian Method Introduction .

At the same time. You can analyze consumer’s equilibrium through the technique of indifference curve and budget line.The goal of a consumer is to get maximum satisfaction from the commodities he purchases. There prevails perfect competition in the market. you could ascertain that a consumer is in equilibrium when he obtains maximum satisfaction from his expenditure on the commodities given the limited resources. Assumptions 1. he is trying to maximize his satisfaction by allocating the available resources (money income) among various goods and services rationally. For instance. The consumer has perfect knowledge about the products available in the market. preferences and spending habits remain unchanged throughout the analysis. 4. Consumer’s indifference map remains unchanged throughout the analysis. According to Prof. 2. The consumer under consideration is a rational human being. This is the main theme of the theory of consumer behavior. Prices of commodities and consumer’s money income are given. 7. Consumer’s tastes. 3.” 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 . the consumer possesses limited resources. Maurice. Hence. 5. “The budget line is the locus of combinations or bundles of goods that can be purchased if the entire money income is spent. Goods are homogeneous and divisible. Price Line or Budget Line Price line or budget line is an important concept in analyzing consumer’s equilibrium. prices of commodities. 6. This means that the consumer always tries to maximize his satisfaction with limited resources. Further.

Let us consider a hypothetical consumer who has a fixed income of $8. he could spend entire money on commodity Y and get 8 units of commodity Y and no commodity X. horizontal axis measures commodity X and vertical axis measure commodity Y. namely X and Y.Suppose there are two commodities. Now. At point Q. The budget line or price line (LM) indicates various combinations of commodity X and commodity Y that the consumer can buy with $8. Given the market prices and the consumer’s income. The consumer could spend all money on X and get 4 units of commodity X and no commodity Y. he wants to spend the entire money on two commodities (X and Y). The slope of the budget line is OL/OM. The table given below exhibits the numerous combinations of X and Y that the consumer can purchase with $8. Alternatively. Suppose the price of commodity X is $2. the consumer is is . the price line shows all the possible combinations of X and Y that a consumer could purchase at a particular time. and the price of commodity Y $1. In figure 1.

. a reduction in consumer’s money income creates a parallel inward shift in the budget line. i. he is able to buy 4 units of commodity Y and 2 units of commodity X.able to buy 6 units of commodity Y and 1 unit of commodity X. 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. The slope of the price line (LM) is the ratio of price of commodity X to price of commodity Y. In our example. the slope of the price line is Px. at point P. Reasons for Many Budget Lines (a) Consumer’s Income Change An outward parallel shift in the budget line occurs because of an increase in consumer’s money income provided that the prices of commodities X and Y remain unchanged (it means constant slope . price of commodity X is $2 and price of commodity Y is $1. hence.e. Likewise. . Px/Py. Similarly.Px/Py).

. Now. He can now buy OM1quantity of commodity X and OL1 quantity of commodity Y. Assume that the price of commodity X decreases and the price of commodity Y remain unchanged. In this case. If his income increases. Hence. LM denotes the initial price line. In figure 3. this scenario is denoted by the shifts in the price line from LM to LM1 then to LM2and so on. if the price of commodity X rises. Assume that the prices of the two goods and consumer’s money income are constant. the price line shifts outward and becomes L 1M1.In figure 2. This leads to the price line shifts from LM2 to LM1 and to LM. Conversely. if there is a decrease in consumer’s income. Similarly. the consumer is able to purchase OM quantity of commodity X or OL quantity of commodity Y. L 3M3). the price line will shift inward (for example. the price ratio Px/Py will rise. A further increase in income causes a further outward shift in the price line to L 2M2. if there is a change in the price of any one of the commodities. the price ratio Px/Py (slope of price line) tends to decrease. Price line L2M2indicates that the consumer can buy OM2 quantity of commodity X and OL2quantity of commodity Y. there will be a change in the slope of the price line. (b) Price Change The slope of a price line is associated with the prices of commodities under consideration.

Indifference Map A set of indifference curves that shows a consumer’s preferences is known as an indifference map. 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. Secondly. marginal rate of substitution must be equal to the ratio of commodity prices. higher indifference curves indicate higher levels of satisfaction. Consumer's Equilibrium . Symbolically. exhibits all properties of a normal indifference curve. MRSxy = MUx/MUY = Px/Py. Necessary conditions for consumer’s equilibrium The following are the two important conditions to attain consumer’s equilibrium: Firstly. they do not touch any of the axes (example: figure 4). The indifference map of a consumer. since is composed of indifference curves. indifference curve must be convex to the origin.

The question now is that how the consumer is going to optimize his limited resources. . To obtain consumer’s equilibrium graphically. The tangency of indifference curve IC2 and the price line represent the above statement. we can understand that the second condition for consumer’s equilibrium (indifference curve must be convex to the origin) is also fulfilled. From figure 5. In other words. you just need to superimpose the budget line on the consumer’s indifference map. This is shown in figure 5.Now we have both budget lines and indifference map of the consumer. At point E. the consumer’s equilibrium means the combination of commodities that maximizes utility. An answer for this question would be consumer’s equilibrium. 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 consumer’s equilibrium). At the point of tangency. A budget line represents consumer’s limited resources (what is feasible) and indifference map represent consumer’s preferences (what is desirable). Because the indifference curve IC 2is the best possible indifference curve that the consumer can reach with the given resources (budget line). given the budget constraint. consumer’s equilibrium is attained.

If the price is higher than P*.A small algebraic manipulation in the above equation gives us MU x/Px = MUy/Py. and Price Ceiling and Floors << Previous Next >> . again bringing the market back to the intersection of supply and demand. Conversely. The combination (X0Y0) is an optimal choice (point E) for the consumer. and a surplus will result. 17. 17:Equilibrium. Thus. all the conditions for consumer’s equilibrium are fulfilled. the quantity supplied in that market will be higher than the quantity demanded at the prevailing price. firms either accumulate inventory (which costs money to store and hold) or they have to discard their extra output. the size of the surplus is given by the quantity supplied minus the quantity demanded. which is the marginal utility per dollar rule for consumer’s equilibrium. Demand and supply equilibrium Introduction….) When a surplus occurs. This is clearly not optimal from a profit perspective. (This time. consider a situation where the price in a market is higher than the equilibrium price. 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. Changes in Supply and Demand.

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. or stronger tastes for the product in question). With a downward-sloping demand curve and an upward-sloping supply curve. and this will result in an increase in the price of the product. if there is an increase in demand (a shift to the right of the demand curve. In the face of a shortage. With a surplus. until the equilibrium point is reached. You can see these changes by starting with a simple supply and demand graph showing an initial equilibrium. this will result in a decline in the equilibrium price and an increase in the equilibrium quantity.Equilibrium Supply and demand come together in the marketplace. quantity demanded will be smaller than the quantity supplied. firms will compete to sell their products. you will need to become proficient at drawing supply and demand graphs and using them to determine the consequences of changes in demand. Changes in Supply and Demand When supply and demand curves shift. and there will be excess supply (a surplus) in the market. or ashortage. and then drawing the new demand or supply curve and observing the new equilibrium point. For example. As with a shortage. If there is an increase in supply (a shift to the right of the supply curve. a decrease in supply will raise the equilibrium price and lower the equilibrium quantity. In order to do well in this course. supply. This is called anequilibrium point. higher prices for a substitute good. . The quantity demanded will be greater than the quantity supplied. this results in changes to the equilibrium price and quantity. A decrease in demand will entail reductions in the equilibrium price and quantity. there will ordinarily be a point of intersection of the two curves. Consider now prices below the equilibrium price. both the equilibrium price and equilibrium quantity will increase. there is no tendency for price or quantity to change. there will be movements along the supply and demand curves as price changes. as might occur with improved technology or reduction in the prices of inputs). and the corresponding price is the equilibrium price while the corresponding quantity is the equilibrium quantity. or both. Conversely. Conversely. as might occur with higher incomes. That point shows the price at which the quantity demanded in the market equals the quantity supplied. consumers will compete with one another for the limited supply. At equilibrium. and this will result in downward pressure on the price of the product. at prices above the equilibrium price. This is referred to as excess demand.

decline in demand. when there is an increase in supply. there is a movement along the curve for the aspect that does not change.The four basic changes (increase in demand. 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. A decline in demand 3. Likewise. Note that in each case. there is an increase in the quantity demanded (downward movement along the demand curve). That is. An increase in demand 2. An increase in supply 4. increase in supply. A decline in supply . 1. reduction in supply) are illustrated in the diagrams below.

But sometimes markets are subject to regulations that prevent them from adjusting to shortages or surpluses. it creates a shortage that persists (since the market price is prevented from rising to its equilibrium level). and that markets allowed to adjust to shortages or surpluses will move to equilibrium. Normally this maximum price is established by some governmental authority. Allocation in these circumstances may be . it is no longer the case that supply.” If this ceiling keeps the market price below the equilibrium price. The product must be rationed via nonprice mechanisms as well. demand. A price ceiling is a maximum price that sellers may charge for a good or service . and price alone can serve to allocate the product to different consumers. where cities establish maximum rents in an effort to keep housing “affordable. A classic example of price ceilings is provided by rent controls.Price Ceilings and Floors We noted above that shortages and surpluses are not equilibrium situations. 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. When price ceilings are in effect and the ceiling price is below the equilibrium price.

based on queuing (lining up to wait for distribution of the good or service). A price floor is a minimum price that must be paid in a market – i. Two examples are the minimum wage and support prices for agricultural products. A shortage exists if the quantity of a good or service demanded exceeds the quantity supplied at the current price. will cause the equilibrium price to rise. it causes downward pressure on price. exchange at a lower price is prohibited. A decrease in supply will cause the equilibrium price to rise. and the quantity demanded will increase until Qd = Qs. it may contribute to higher unemployment than would exist in the absence of a minimum wage. nonprice rationing will be utilized. and in the farm price support example it will translate into a need to cope with growing surpluses of agricultural products.  An increase in supply. quantity demanded will  increase. or black markets (where illegal trading takes place at market-determined prices). This surplus typically will create some problems.e.  A surplus exists if the quantity of a good or service supplied exceeds the quantity demanded at the current price. . quantity supplied will decrease. the quantity supplied will also decrease. it causes upward pressure on price. It is determined by the intersection of the demand and supply curves. what will likely happen to the price. quantity demanded will decrease. the quantity demanded. A decrease in demand will cause the equilibrium price to fall. There will be a tendency for the price of the product to drop. Practice Problem 1: Equilibrium.  An increase in demand. and the quantity supplied? If the actual price of a good is above the equilibrium price. In the minimum wage example. Governmental bodies typically establish price floors. all other things unchanged. then there will be excess supply of that product (Qs > Qd). will cause the equilibrium price to fall. Again. As this happens. K E Y TA K E AWAY S  The equilibrium price is the price at which the quantity demanded equals the quantity supplied. all other things unchanged. rationing coupons. Changes in Supply and Demand and Price Çeilings and Floors If the actual price of a good is above the equilibrium price. If a price floor keeps the market price above the equilibrium price.. quantity supplied will increase. it creates a surplus that persists (since the market price is prevented from falling to its equilibrium level).

Canara Bank.09C. and 09): The two most distinctive features of a commercial bank are borrowing and lending. 09. as their name suggests. 08.e. 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. i. Bank of Baroda. A05. acceptance of deposits and lending of money to projects to earn Interest (profit)..  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. 07. Allahabad Bank. commercial banks.. you must know in which direction each of the curves shifts and the extent to which each curve shifts. 40. Andhra Bank. 06. Function. In fact. axe profit-seeking institutions. In short. banks borrow to lend. Function.Commercial Bank: Definition. i. .08C. 06. Credit Creation and Significances Commercial Bank: Definition. they do banking business to earn profit. To determine what happens to equilibrium price and equilibrium quantity when both the supply and demand curves shift. 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 profit. Most of the Indian joint stock Banks are Commercial Banks such as Punjab National Bank. 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. They generally finance trade and commerce with short-term loans.e. etc. Functions of Commercial Banks (D05.

\ (ii) Fixed deposits (Time deposits): . savings and fixed deposits. The first task is. The bank does not pay any Interest on these deposits but provides cheque facilities. Let us know about each of them: (A) Primary Functions: 1. firms and finances the temporary needs of commercial transactions. called demand deposits.The difference between the rates is called ‘spread’ which is appropriated by the banks. Functions of commercial banks are classified in to two main categories—(A) Primary functions and (B) Secondary functions. It accepts deposits: A commercial bank accepts deposits in the form of current. Deposits are the lifeline of banks. Deposits are of three types as under: (i) Current account deposits: (ii) Such deposits are payable on demand and are. These accounts are generally maintained by businessmen and Industrialists who receive and make business payments of large amounts through cheques. therefore. It collects the surplus balances of the Individuals. These can be withdrawn by the depositors any number of times depending upon the balance in the account. therefore. the collection of the savings of the public. The bank does this by accepting deposits from its customers. 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. Mind. For example post offices are not bank because they do not give loans.

(iv) Demand deposits are chequable deposits whereas time deposits are not. 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. the main source of income of the bank.. are deposits which are payable only after the expiry of the specified period. This is. 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. Interest paid on savings account deposits in lesser than that of fixed deposit. They are payable on demand and also withdraw able by cheque. Term deposits. They combine the features of both current account and fixed deposits.e. i. period of time ranging from a few days to a few years. A bank keeps a certain portion of the deposits . They can be withdrawn only after the maturity of the specified fixed period. 2.. in fact. 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.Fixed deposits have a fixed period of maturity and are referred to as time deposits. 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. e. They carry higher rate of interest.g.g. (iii) Demand deposits are highly liquid whereas time deposits are less liquid. (iii) Savings account deposits: These are deposits whose main objective is to save. Savings account is most suitable for individual households. (ii) Demand deposits do not carry interest whereas time deposits carry a fixed rate of interest. a bank may allow four or five cheques in a month. These are neither payable on demand nor they enjoy cheque facilities. also called time deposits.. These are deposits for a fixed term. No interest is paid on them. e. But bank gives this facility with some restrictions.

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. (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 entire amount is repaid either in one instalment or in a number of instalments over the period of loan.with itself as reserve and gives (lends) the balance to the borrowers as loans and advances in the form of cash credit. overdraft as explained under. The withdrawing power depends upon the borrower’s current 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. Investment: Commercial banks invest their surplus fund in 3 types of securities: (i) Government securities. Interest is charged by the bank on the drawn or utilised portion of credit (loan). (B) Secondary Functions: Apart from the above-mentioned two primary (major) functions. (ii) Demand Loans: A loan which can be recalled on demand is called demand loan. Banks earn interest on these securities. commercial banks perform the following secondary functions also. (ii) Other approved securities and (iii) Other securities. the stock statement of which is submitted by him to the bank as the basis of security. 3. take such loans on personal security and financial assets. Discounting bills of exchange or bundles: . There is no stated maturity. demand loans. short-run loans.

Suppose. It is a facility to a depositor for overdrawing the amount than the balance amount in his account. A buys goods from B. 4. (iii) Whereas the borrower of loan pays Interest on amount outstanding against him but customer of overdraft pays interest on the daily balance. then the bank should grant overdraft and honour the cheque. debentures. Alternatively. etc. the borrower has to pay interest on full amount sanctioned but in the case of overdraft.A bill of exchange represents a promise to pay a fixed amount of money at a specific point of time in future. (ii) In the case of loan. a bill of exchange is a document acknowledging an amount of money owed in consideration of goods received. Difference between Overdraft facility and Loan: (i) Overdraft is made without security in current account but loans are given against security. Suppose. It can also be encashed earlier through discounting process of a commercial bank. 5. 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. 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. The security for overdraft is generally financial assets like shares. life insurance policies of the account holder. It works like this. 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. 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. It is a paper asset signed by the debtor and the creditor for a fixed amount payable on a fixed date. Agency functions of the bank: . When the bill matures after specified period. B wants the money immediately. the bank will get payment from A. In other words. the borrower is given the facility of borrowing only as much as he requires.

etc. . (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.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. (iv) Acts as Trustee and Executor of property of its customers on advice of its customers. etc. (ii) Collection of funds: It collects funds through cheques. bundles and demand drafts on behalf of its customers.The banks issue traveler’s cheques and gift cheques. mail transfers. (iii) Payments of various items: It makes payment of taxes. (v) Collection of dividends. bills. bills. Performing general utility services: The banks provide many general utility services. 6. interest on shares and debentures is made on behalf of its customers. telegraphic transfers. some of which are as under: (i) Traveller’s cheques . Insurance premium. as per the directions of its customers. (iv) Purchase and sale of shares and securities: It buys sells and keeps in safe custody securities and shares on behalf of its customers.

banks are able to create credit through secondary deposits many times more than initial deposits (primary deposits). Mind. In the process of lending money. Y who is actually not . 11.000 with a bank and the LRR is 10%.) The bank lends Rs 1800 to. loan is never given in cash but it is redeposited in the bank as demand deposit in favour of borrower. public or private bodies. which means the bank keeps only the minimum required Rs 200 as cash reserve (LRR). (Mind.e.e. initial cash deposits and (ii) Legal Reserve Ratio (LRR). (iii) Underwriting securities issued by government. deposits Rs 2. (iv) Purchase and sale of foreign exchange (currency). The customers can keep their ornaments and important documents in lockers for safe custody. 10C.(ii) Locker facility.. i. 11. Process of money (credit) creation: Suppose a man. How? It is explained below. Broadly when a bank receives cash deposits from the public. The bank can use the remaining amount Rs 1800 (= 2000 – 200) for giving loan to someone. say X. Credit (Money) Creation by Commercial Banks (A10. D10. 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. 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. say.) Money creation by commercial banks is determined by two factors namely (i) Primary deposits i. minimum ratio of deposits which is legally compulsory for the commercial banks to keep as cash in liquid form. it keeps a fraction of deposits as cash reserve (LRR) and uses the remaining amount for giving loans.

say. This is the first round of credit creation in the form of secondary deposit (Rs 1800). says Rs 18000. He is simply given the cheque book to draw cheques when he needs money. This is second round of credit creation which is 90% of first round of increase of Rs 1800. volume of total credit created in this way becomes multiple of initial (primary) deposit.1. The third round of credit creation will be 90% of second round of 1620.. which equals 90% of primary (initial) deposit. then money multiplier = 1/0. The bank gets new demand deposit of Rs 1620..e. 10/100or 0. If the bank succeeds in creating total credit of. 20% of Sohan’s 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. Money Multiplier: It means the multiple by which total deposit increases due to initial (primary) deposit. This is what is meant by credit creation. Thus. larger would be the size of money multiplier credited to his account. The multiple is called credit creation or money multiplier. In short. it means bank has created 9 times of primary (initial) deposit of Rs 2000. money (or credit) creation by commercial banks is determined by (i) amount of initial (primary) deposits and (ii) LRR. Mohan. Again 10% of Y’s deposit (i.e. This is not the end of story. Smaller the LRR. In the end. Symbolically: Total Credit creation = Initial deposits x 1/LPR.given loan but only demand deposit account is opened in his name and the amount is credited to his account. the process of . i.1 = 10. The quantitative outcome is called money multiplier. If LRR is 10%. Rs 180) is kept by the bank as cash reserve (LRR) and the balance Rs 1620 (=1800 – 180) is advanced to. Z. The process of credit creation goes on continuously till derivative deposit (secondary deposit) becomes zero. Money multiplier (or credit multiplier) is the inverse of Legal Reserve Ratio (LRR). Again.

Rs 15. etc. This is also called credit creation. Scheduled Banks and Non-scheduled Banks: Commercial banks are classified in two broad categories—scheduled banks and non- scheduled banks. 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. say. As a result of credit creation. the bank creates credit when it buys securities and pays the seller with its own cheque. Types of Commercial Banks: The following chart depicts main types of commercial banks in India.000. Scheduled banks are those banks which are included in Second Schedule of Reserve Bank of India. nationalised banks. Similarly. Some of important scheduled banks are State Bank of India and its subsidiary banks. The cheque is deposited in some bank and a deposit (credit) is created for the seller of securities. foreign banks. This is what is meant by credit creation. RBI provides special facilities including credit to scheduled banks. 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.credit creation goes on continuously and in the end volume of total credit created in this way becomes multiple of initial cash deposit.000. A scheduled bank must have a paid-up capital and reserves of at least Rs 5 lakh. it means that the bank has created credit 15 times of the primary deposit of Rs 1. . money supply in the economy becomes higher. If the bank succeeds in creating credit of.

etc. “Bank is the heart and central point of modern exchange economy. Post office saving bank. A non-scheduled bank has a paid-up capital and reserves of less than Rs 5 lakh. A passing reference to some other types of commercial banks will be informative. In the words of Wick-sell. Foreign Exchange Banks are commercial banks which are branches of foreign banks and facilitate international financial transactions through buying and selling of foreign bills. 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..Non-scheduled Banks: The banks which are not included in Second Schedule of RBI are known as non- scheduled banks. such banks are small banks and their field of operation is also limited.g. Saving Banks mobilise small savings of the people in savings account. plants. . They advance loans to their members at fair rate of interest. e. Clearly. trade and industry of a country.” 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. Industrial Banks provide finance to industrial concerns by subscribing (buying) shares and debentures of companies and also give long-term loans to acquire machinery. They constitute nerve centre of production. (iii) They promote balanced regional development by opening branches in backward areas. Cooperative Banks are organised by the people for their own collective benefits. Agricultural Banks finance agriculture and provide long-term loans for buying tractors and installing tube-wells.

(vii)They help commerce and industry to expand their field of operation. (v) They help in promoting large-scale production and growth of priority sectors such as agriculture. 39. For example. the quantity theory of money states that money supply has a direct. if the currency in circulation increased. there would be a proportional increase in the price of goods. retail trade and export. they make optimum utilisation of resources possible. proportional relationship with the price level. (vi) They create credit in the sense that they are able to give more loans and advances than the cash position of the depositor’s permits. small-scale industry.Quantity theory of money In monetary economics. (viii) Thus.[1] .(iv) Bank credit enables entrepreneurs to innovate and invest which accelerates the process of economic development.

causing inflation (the percentage rate at which the level of prices is rising in an economy). 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. 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. price levels also double. As gold and silver inflows from the Americas into Europe were being minted into coins. Here we look at the assumptions and calculations underlying the QTM. The consumer therefore pays twice as much for the same amount of the good or service. if the amount of money in an economy doubles. there was a resulting rise in inflation. as well as its relationship to monetarism and ways the theory has been challenged. According to QTM. The Theory's Calculations In its simplest form.What Is the Quantity Theory of Money? By Reem HeakalAAA | Related Searches: Supply Side Economics Fiscal Policy Keynesian Economics Inflation Adam Smith Economist The concept of the quantity theory of money (QTM) began in the 16th century. 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). the theory is expressed as: . So an increase in money supply causes prices to rise (inflation) as they compensate for the decrease in money's marginal value.

The theory also assumes that the quantity of money. The arguments point out that the velocity of circulation depends on consumer and business spending impulses. and those $3 were spent five times in a month. the theory assumes that V (velocity of circulation) and T (volume of transactions) are constant in the short term. is the main influence of economic activity in a society. particularly the assumption that V is constant. and Milton Friedman. These assumptions. A change in money supply results in changes in price levels and/or a change in supply of goods and services. And the velocity of circulation depends not on the amount of money available or on the current price level but on changesin price levels. which is determined by outside forces. have been criticized. see Free Market Maven: Milton Friedman. In its most basic form. (For more on this important economist. who formulated the above equation.) 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.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. QTM Assumptions QTM adds assumptions to the logic of the equation of exchange. however. total spending for the month would be $15. It is primarily these changes in money stock that cause a change in spending. which cannot be constant. .

the purchasing power. decreases. the theory's assumptions imply that the value of money is determined by the amount of money available in an economy. Less orthodox monetarists. (For more insight. 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. capital. it forms the cornerstone of monetarism. Monetarists believe that money supply should be kept within an acceptable bandwidth so that levels of inflation can be controlled. It therefore will cost more to buy the same quantity of goods or services. employment levels. the factors of production). 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. Inflation and Monetarism As QTM says that quantity of money determines the value of money. The theory assumes an economy in equilibrium and at full employment. In order to curb inflation. knowledge and organization.) Monetarists say that a rapid increase in money supply leads to a rapid increase in inflation. or the value of money. however. Monetarists believe that instead of governments continually adjusting economic policies (i.Finally. This premise leads to how monetary policy is administered. 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. natural resources (i. for the near term. government spending and taxes). As inflation rises. most monetarists agree that an increase in money supply can offer a quick-fix boost to a staggering economy in need of increased production. the number of transactions (T) is determined by labor. Money Supply.e. see Monetarism: Printing Mone To Control Inflation. the effects of monetary policy are still blurry. spending and so forth).e. on the other hand. it is better to . hold that an expanded money supply will not have any effect on real economic activity (production. money growth must fall below growth in economic output. Essentially. Thus. In the long term.

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.

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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
believe'.

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
output.

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).

If output increases by that same proportional change as all inputs change then there are constant returns to scale (CRS). The Laws Of Returns to Scale Introduction . there are increasing returns to scale (IRS). decreasing returns at relatively high output levels.The laws of returns to scale are a set of three interrelated and sequential laws: Law of Increasing Returns to Scale. the returns to scale faced by a firm are purely technologically imposed and are not influenced by economic decisions or by market conditions (i. and constant returns at one output level between those ranges. there are decreasing returns to scale (DRS).. there could be increasing returns at relatively low output levels. conclusions about returns to scale are derived from the specific mathematical structure of the production function in isolation).[citation needed] In mainstream microeconomics.e. Law of Constant Returns to Scale. Typically. A firm's production function could exhibit different types of returns to scale in different ranges of output. If output increases by more than that proportional change in inputs. and Law of Diminishing returns to Scale. If output increases by less than that proportional change in inputs.

Techniques of production remains constant. Returns are measured in physical terms.Long run is a period during which all factors of production can vary. All units of factors are homogeneous.A firm's production function could exhibit different types of returns to scale in different ranges of output. Therefore in the long run output can be changed by changing all the factors of production. less than proportionately or in exactly same proportion of the change in quantities of inputs. 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. 3.In the long run production function. Long run relationship between inputs and output of a firm is explained by the Laws of returns to scale. Statement of Law "Other things being equal in the long run. there could be Increasing returns to scale. the output may rise either more than proportionately. as the firm increases the quantities of all factors employed. all factors are variable.Typically. 2.Constant returns to scale and Diminishing returns to scale. . Assumptions 1. The term returns to scale arises in the context of a firm's Production Function.

The scale line OS is drawn which shows the expansion path of a firm. OA > AB > BC.Improvement in large scale operation .e. Example: 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.Internal economies of scale b.In the following figure that the units of labour are measured on X-axis and units of capital on Y axis. In this case the distance between every successive isoquants becomes smaller and smaller i. The Constant Returns to Scale 3. It shows that output doubles itself even before the inputs can be doubled. Diagram In case of increasing returns to scale. Causes of Increasing Returns to Scale: a. The Increasing Returns to Scale 2. The Diminishing Returns to Scale Explanation of Different Stages of Laws of Returns to Scale 1. the production function is homogeneous of degree greater than one. 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.Efficiency of labour and capital c. Stages of Laws of Returns to Scale 1.

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. the output also doubles. Example : 100 units (IQ1 at L) = 3L + 3K 200 units (IQ2 at M) = 6L + 6K 300 units (IQ3 at N) = 9L + 9K Diagram Causes of Constant Returns to Scale: a)Internal economics of scale are equal to internal diseconomies of scale. In case of constant returns to scale.External economies of scale 2. . It means if units of labour and capital are doubled. OS is the scale of operation line. production function is homogenous of degree one.d. It shows that if inputs are doubled then the output also gets doubled. In this case the distance between every successive isoquant remains equal i. the units of labour are measured on X-axis and units of capital on Y-axis.Use of better and sophisticated technology f. OL = LM = MN.Division of labour and specialization e.Economy of organisation g.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.e. If inputs are trebled then the output also trebles Symbolically: Where Proportionate Change in input In the following figure.

where. In this case. Symbolically : Where: Proportionate change in output. we need to start with a few definitions. i. . a larger proportionate increase in both labour and capital are required.Lack of entrepreneurial efficiency e. to get an equal increase in output.External diseconomies of scale c.Internal diseconomies of scale b.e.Transport bottlenecks and Marketing difficulties. production function is homogenous of degree less than one.Increase in business risk d.Unhealtny management and organization f.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. 23-25… cost consept & cost curve Costs and their Curves  Before we look at the cost curves in detail. Following figure shows the decreasing returns.3. In case of decreasing returns to scale the distance between every successive isoquant on expansion path becomes larger and larger.Imperfect factor substitutability g. Example: 100 units (IQ. at P) = 3L + 3K 200 units (IQ2 at Q) = 7L + 7K 300 units (IQ3 at R) = 12L +12K Diagram Causes of Decreasing Returns to Scale a. OP < PQ < QR.

What does an economist mean by the economic cost of production? This is theopportunity cost of production. by definition. In a sense. machinery. If a firm wants to make more chocolate. but some textbooks refer to it as semi-variable.. marginal and average product in the last Learn-It. A cost is either fixed or variable. for example. If they need to increase output. per unit of output produced. As you have probably read in more textbooks than you care to remember. If a cost is not fixed. the workers will be asked to do overtime. Total. this is the value that could have been generated had the resources been employed in their next best use. . The best example is raw materials. marginal and average costs As with total. average and marginal cost. Average cost (AC). Average cost is often called average total cost so as to distinguish it from AFC and AVC. Variable costs. Total cost (TC). economists like to start with a more abstract term. Examples include rent. Labour is also a variable cost. but employers are nervous about employing someone permanently who may not be required in the long term. This can be sub-divided. It is also important that you understand the difference between fixed cost and variable costs. this is still variable. There is no third group. but the actual number of workers may not. office costs and. If a firm made 100 bars of chocolate at a total cost of £10. raw materials. Remember that this concept of opportunity cost is useful when dealing with production possibility frontiers. certainly in the short run. surprise surprise. it must vary with output. it will need more cocoa beans and sugar. Total cost = total fixed costs + total variable costs (or TC = TFC + TVC). Fixed costs are those that do not vary as output increases. This is the total cost to the firm of producing a given number of units. the actual number of workers employed will eventually rise. Of course. because the number of man-hours worked will still rise. per bar of chocolate produced. then. etc. Many firms have a fairly permanent staff. This is the cost. we first need to define total. on average. So. is 10p. algebraically: It also follows that average cost = average fixed cost + average variable cost (AC = AFC + AVC). if a firm is planning some serious expansion.Although we will be looking at the costs of a firm in terms of wages. on average. This is derived by simply dividing both sides of the total cost equation by Q. The cost of letting a permanent member of staff go can be much higher than sacking a part-time or contract worker. are costs that do vary as output increases. then the cost.

It is the extra cost at the margin (i. . in turn. 16. by producing the marginal unit of output). This is the additional cost incurred by a firm as a result of producing one more unit of output. The average variable cost curve comes from the product curves in exactly the same way 25-27 Revenue: The Meaning and Concept of Revenue | Micro Economics Read this article to learn about the meaning and concept of revenue. Total Revenue. then the amount of Rs.000 from sale of 100 chairs. which are. For example.. as sales increases. How the cost curves are derived It is important to understand why the cost curves look like they do. Average Revenue and Marginal Revenue. So the marginal cost and average cost curves come from the product curves.e. 16. Revenue refers to the amount received by a firm from the sale of a given quantity of a commodity in the market. i. revenue also increases.e.000 is known as revenue.Marginal cost (MC). derived from thelaw of diminishing marginal returns. micro economics! Meaning of Revenue: The amount of money that a producer receives in exchange for the sale proceeds is known as revenue. Revenue is a very important concept in economic analysis. Concept of Revenue: The concept of revenue consists of three important terms. The concept of Diminishing marginal Returns is the one from which we derive the cost curves. if a firm gets Rs. It is directly influenced by sales level.

600. Since sellers receive revenue according to price. 160 per chair is Rs. then: Average Revenue = Total Revenue/Quantity = 1. Average Revenue = Total Revenue/Quantity For example. then the total revenue will be: 10 Chairs × Rs. It is the total income of a firm.600 Average Revenue (AR): Average revenue refers to revenue per unit of output sold.Total Revenue (TR): Total Revenue refers to total receipts from the sale of a given quantity of a commodity. 160 per chair. 160 = Rs 1. 1. if total revenue from the sale of 10 chairs @ Rs. Total revenue is obtained by multiplying the quantity of the commodity sold with the price of the commodity. if a firm sells 10 chairs at a price of Rs. Total Revenue = Quantity × Price For example. price and AR are one and the same thing. This can be explained as under: TR = Quantity × Price … (1) . AR is equal to per unit sale receipts and price is always per unit.600/10 = Rs 160 AR and Price are the Same: We know. It is obtained by dividing the total revenue by the number of units sold.

we get AR = Quantity × Price / Quantity AR = Price AR Curve and Demand Curve are the Same: A buyer’s demand curve graphically represents the quantities demanded by a buyer at various prices. .600 and that from sale of 14 chairs is Rs. In other words. it is customary to refer AR curve as the Demand Curve of a firm. then the marginal revenue will be: MR = TR of 14 chairs – TR of 10 chairs / 14 chairs -10 chairs = 600/4 = Rs. it shows the various levels of average revenue at which different quantities of the good are sold by the seller. Therefore. Marginal Revenue (MR): Marginal revenue is the additional revenue generated from the sale of an additional unit of output. in economics.AR = TR/Quantity …… (2) Putting the value of TR from equation (1) in equation (2). 1. 2.200. 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. 150 TR is summation of MR: Total Revenue can also be calculated as the sum of marginal revenues of all the units sold.

it may be a place. "Market refers to an arrangement. This fact can be explained with the help of the following statement. to buy or sell goods.g. In Economics. the buyer and seller can carry on their transactions through internet." Thus. here forms an arrangement and such arrangement also is included in the market. . Market means a place where buyer and seller meets together in order to carry on transactions of goods and services. above statement indicates that face to face contact of buyer and seller is not necessary for market. So internet. market can exist even without direct contact of buyer and seller. But in Economics. Types or Classification of Market What is Market? Meaning Usually. Classification or Types of Market The classification or types of market are depicted in the following chart.31-33What is Market? Meaning. perhaps may not be. E. In stock or share market. whereby buyers and sellers come in contact with each other directly or indirectly.

Short Period Market. the market is classified into: 1. the market is classified on the basis of: 1. On the basis of Time. . Time and 3. 3. 2. 2. National Market or Countrywide Market.Generally. Very Short Period Market. 2. the market is classified into: 1. Local Market or Regional Market. International Market or Global Market. Place. Competition. On the basis of Place.

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. Meaning of Market: Ordinarily. in economics. etc. The structures of market both for goods market and service (factor) market are determined by the nature of competition prevailing in a particular market. Perfectly Competitive Market Structure. the term “market” refers to a particular place where goods are purchased and sold. market is used in a wide . But. 2. 1. On the basis of Competition. 4. the market is classified into: 1. The suffix poly has its origin from Greek word Polus which means many or more than one Market Structure: Meaning. 3. there are different forms of markets like monopoly. price. Very Long Period Market. oligopoly and monopolistic competition. Imperfectly Competitive Market Structure. Monopolistic competition has many or several numbers of sellers. 4. duopoly. Duopoly has two (duo) sellers. Oligopoly has little or fewer (oligo) number of sellers. 3. Under imperfect competition. Long Period Market. Both these market structures widely differ from each other in respect of their features. 2. A monopoly has only one or a single (mono) seller.

internet. telegrams. Thus. Characteristics of Market 3. the term “market” does not mean a particular place but the whole area where the buyers and sellers of a product are spread. easily and quickly. “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. According to Prof. Cournot. Contents : 1. Meaning of Market 2.” Prof. In these transactions. Chapman.A. “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. In economics. the price of a commodity is the same in the whole market. Forms of Market Structure Characteristics of Market: The essential features of a market are: . The transactions for commodities may be also through letters. Cournot’s definition is wider and appropriate in which all the features of a market are found.perspective. Hence. the sellers and buyers of a particular commodity are spread over a large area. This is because in the present age the sale and purchase of goods are with the help of agents and samples. etc. market in economics does not refer to a particular market place but the entire region in which goods are bought and sold. telephones. R. Market Structure 4.

(2) One Commodity: In economics. there are separate markets for various commodities. For example. etc.(1) An Area: In economics. internet. Modem modes of communication and transport have made the market area for a product very wide. 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. jewellery. In the modem age. telephones. (4) Free Competition: There should be free competition among buyers and sellers in the market. etc. On the basis of above elements of a market. its general definition may be as follows: . business representatives. the presence of buyers and sellers is not necessary in the market because they can do transactions of goods through letters. a market does not mean a particular place but the whole region where sellers and buyers of a product ate spread. Hence. there are separate markets for clothes. (3) Buyers and Sellers: The presence of buyers and sellers is necessary for the sale and purchase of a product in the market. a market is not related to a place but to a particular product. grains.

They are: (1) The number and nature of sellers. Market Structure: Meaning: Market structure refers to the nature and degree of competition in the market for goods and services. They are discussed as under: 1. to two sellers . (5) Economies of scale. (3) The nature of the product. (4) The conditions of entry into and exit from the market. (2) The number and nature of buyers.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. They range from large number of sellers in perfect competition to a single seller in pure monopoly. Number and Nature of Sellers: The market structures are influenced by the number and nature of sellers in the market. The structures of market both for goods market and service (factor) market are determined by the nature of competition prevailing in a particular market. Determinants: There are a number of determinants of market structure for a particular good.

it has no close substitutes and there is pure monopoly in the market. 2. to a few sellers in oligopoly. But in monopoly and oligopoly markets. governments have a monopoly in public utility services like postal. Number and Nature of Buyers: The market structures are also influenced by the number and nature of buyers in the market. Usually. sugarcane. when local factories purchase the entire crops for processing. etc. In a perfect competition market. 3. and to many sellers of differentiated products. This is called duopsony market. Entry and Exit Conditions: The conditions for entry and exit of firms in a market depend upon profitability or loss in a particular market. If there is product differentiation. the market is characterised by perfect competition. there are barriers to entry of new firms. water and power supply . there is freedom of entry or exit of firms.in duopoly. Nature of Product: It is the nature of product that determines the market structure. Duopsony and oligopsony markets are usually found for cash crops such as rice. They may also be a few organised buyers of a product. On the other hand. in case of no product differentiation. products are close substitutes and the market is characterised by monopolistic competition. this is buyer’s monopoly and is called monopsony market. And if a product is completely different from other products. air and road transport. There may be two buyers who act jointly in the market. Profits in a market will attract the entry of new firms and losses lead to the exit of weak firms from the market. Such markets exist for local labour employed by one large employer. If there is a single buyer in the market. 4. This is known as oligopsony.

Duopoly 4. all engaged in buying and selling a homogeneous product without any artificial restrictions and possessing perfect knowledge of market at a time. In oligopoly markets. Economies of Scale: Firms that achieve large economies of scale in production grow large in comparison to others in an industry. there is monopoly.services. If only one firm attains economies of scale to such a large extent that it is able to meet the entire market demand. This leads to the emergency of oligopoly. etc. a market can be classified in the following ways: 1. Forms of Market Structure: On the basis of competition. In the words of A. Oligopoly 5. On the other hand. tacit agreements. there are no restrictions in entry and exit of firms in monopolistic competition due to product differentiation. 5. Perfect Competition Market: A perfectly competitive market is one in which the number of buyers and sellers is very large. etc. “Perfect competition is a market structure . entries of new supplies are barred. By granting exclusive franchises. Monopolistic Competition 1. Koutsoyiannis. Monopoly 3. They tend to weed out the other firms with the result that a few firms are left to compete with each other. Perfect Competition 2. there are barriers to entry of firms because of collusion. cartels.

takers and in which there is freedom of entry into. (3) Homogeneous Product: . Similarly. the individual seller is unable to influence the price of the product by increasing or decreasing its supply. “Perfect competition is a market structure in which all firms in an industry are price. Rather. He is “output adjuster”. attracted by these profits some new firms enter the industry. he adjusts his supply to the price of the product. It implies that whenever the industry is earning excess profits. In other words. In case of loss being sustained by the industry.” According to R.characterised by a complete absence of rivalry among the individual firms. He is a “price taker”.G. Thus no buyer or seller can alter the price by his individual action. and exit from. Lipsey. industry. 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. (2) Freedom of Entry or Exit of Firms: The next condition is that the firms should be free to enter or leave the industry. He has to accept the price for the product as fixed for the whole industry.” Characteristics of Perfect Competition: The following are the conditions for the existence of perfect competition: (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. some firms leave it. 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.

there is no discrimination on the part of buyers or sellers. (5) Profit Maximisation Goal: Every firm has only one goal of maximising its profits. 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. The movement of prices is unfettered. Moreover. wheat. In other words. (4) Absence of Artificial Restrictions: The next condition is that there is complete openness in buying and selling of goods. prices are liable to change freely in response to demand- supply conditions. demand or price of the products. There are no efforts on the part of the producers. He cannot raise the price of his product. Sellers are free to sell their goods to any buyers and the buyers are free to buy from any sellers. Commodities like salt. The above two conditions between themselves make the average revenue curve of the individual seller or firm perfectly elastic. (6) Perfect Mobility of Goods and Factors: Another requirement of perfect competition is the perfect mobility of goods and factors between industries. If he does so. his customers would leave him and buy the product from other sellers at the ruling lower price. No seller has an independent price policy. horizontal to the X-axis. the government and other agencies to control the supply. In other words. the cross elasticity of the products of sellers is infinite. This is only possible if units of the same product produced by different sellers are perfect substitutes.Each firm produces and sells a homogeneous product so that no buyer has any preference for the product of any individual seller over others. cotton and coal are homogeneous in nature. Goods are free to move to those .

If transport costs are added to the price of the product. do not arise because all firms produce a homogeneous product. This condition is essential for the existence of perfect competition which requires that a commodity must have the same price everywhere at any time.places where they can fetch the highest price. Perfect Competition vs Pure Competition: Perfect competition is often distinguished from pure competition. etc. Buyers and sellers possess complete knowledge about the prices at which goods are being bought and sold. (7) Perfect Knowledge of Market Conditions: This condition implies a close contact between buyers and sellers. the costs of advertising.” whereas perfect competition involves perfection in many other respects than in the absence of monopoly.” The practical importance . Factors can also move from a low-paid to a high-paid industry. and of the prices at which others are prepared to buy and sell. pure competition means. 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. even a homogeneous commodity will have different prices depending upon transport costs from the place of supply. 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. (9) Absence of Selling Costs: Under perfect competition. (8) Absence of Transport Costs: Another condition is that there are no transport costs in carrying of product from one place to another. They have also perfect knowledge of the place where the transactions are being carried on. competition unalloyed with monopoly elements. sales-promotion.

He is a price-maker who can set the price to his maximum advantage. Monopoly Market: Monopoly is a market situation in which there is only one seller of a product with barriers to entry of others.” Thus the monopoly firm is itself an industry and the monopolist faces the industry demand curve. once he selects his output level. According to D. Chamberlin says that perfect competition is a rare phenomenon. given the tastes. and incomes of his customers. He can do either of the two things. relatively stable and slopes downward to the right. . However. yet perfect competition is studied for the simple reason that it helps us in understanding the working of an economy. That is why. his output is determined by what consumers will take at that price. A hypothetical model of a perfectly competitive industry provides the basis for appraising the actual working of economic institutions and organisations in any economy. It means that more of the product can be sold at a lower price than at a higher price. The cross elasticity of demand with every other product is very low. This means that no other firms produce a similar product. In any situation.” Though the real world does not fulfil the conditions of perfect competition. The product has no close substitutes. His price is determined by his demand curve. once he sets the price for his product. the ultimate aim of the monopolist is to have maximum profits.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. 2. it does not mean that he can set both price and output. Salvatore. where competitive behaviour leads to the best allocation of resources and the most efficient organisation of production. The demand curve for his product is. “Monopoly is the form of market organisation in which there is a single firm selling a commodity for which there are no close substitutes. Or. therefore.

Under monopoly a firm itself is an industry. 2. there is one producer or seller of a particular product and there is no difference between a firm and an industry. under monopoly. Under monopoly. the cross elasticity of demand for a monopoly product with some other good is very low. Monopolist cannot determine both the price and quantity of a product simultaneously. A monopolist has full control on the supply of a product. 7. 9. 8. There are restrictions on the entry of other firms in the area of monopoly product. 3. A monopolist can influence the price of a product. This is because a monopolist has to cut down the price of his product to sell an additional unit. Pure monopoly is not found in the real world. Hence. There is no close substitute of a monopolist’s product in the market.Characteristics of Monopoly: The main features of monopoly are as follows: 1. a monopolist can increase his sales only by decreasing the price of his product and thereby maximise his profit. not a price-taker. Hence. The marginal revenue curve of a monopolist is below the average revenue curve and it falls faster than the average revenue curve. 4. the elasticity of demand for a monopolist’s product is zero. He is a price- maker. . Monopolist’s demand curve slopes downwards to the right. 6. That is why. 5. A monopoly may be individual proprietorship or partnership or joint stock company or a cooperative society or a government company.

’ With only a few firms in the market. then he considers both the direct and the indirect influences upon the price. Imperfect oligopoly is found among producers of such consumer goods as automobiles. etc.3. Even though they are independent. Both the sellers are completely independent and no agreement exists between them. cement. in that case he takes only his own direct influence on the price. and may set a chain of reactions. cigarettes. a change in the price and output of one will affect the other. steel. It is difficult to pinpoint the number of firms in ‘competition among the few. A seller may. copper. refrigerators. Duopoly: Duopoly is a special case of the theory of oligopoly in which there are only two sellers. typewriters. soaps and detergents. however. each seller takes into account the effect of his policy on that of his rival and the reaction of the rival on himself again. Oligopoly: Oligopoly is a market situation in which there are a few firms selling homogeneous or differentiated products. on the other hand. The former is called pure or perfect oligopoly and the latter is called imperfect or differentiated oligopoly. rubber tyres. Pure oligopoly is found primarily among producers of such industrial products as aluminium. . zinc. If. 4. Moreover. Thus the duopoly problem can be considered as either ignoring mutual dependence or recognising it. An oligopoly industry produces either a homogeneous product or heterogeneous products. a rival seller’s policy may remain unaltered either to the amount offered for sale or to the price at which he offers his product. assume that his rival is unaffected by what he does. TVs. the action of one firm is likely to affect the others. etc.

Each oligopolist firm knows that changes in its price. “Under oligopoly advertising can become a life-and-death matter. It is for this reason that oligopolist firms spend much on advertisement and customer services. Baumol. each produces a considerable fraction of the total output of the industry and can have a noticeable effect on market conditions.” For example.Characteristics of Oligopoly: In addition to fewness of sellers. etc. 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. As pointed out by Prof. most oligopolistic industries have several common characteristics which are explained below: (1) Interdependence: There is recognised interdependence among the sellers in the oligopolistic market. every move by one seller leads to counter-moves by the others. Thus. When the sellers are a few. product characteristics. if all oligopolists continue to spend a lot on advertising their products and one seller . Each seller has direct and ascertainable influences upon every other seller in the industry. advertising. (2) Advertisement: The main reason for this mutual interdependence in decision making is that one producer’s fortunes are dependent on the policies and fortunes of the other producers in the industry. Thus there is complete interdependence among the sellers with regard to their price-output policies. may lead to counter- moves by rivals. 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.

They may be: (a) Economies of scale enjoyed by a few large firms. one oligopolist advertises his product. (3) Competition: This leads to another feature of the oligopolistic market. A symmetrical situation with firms of a uniform size is rare. (b) control over essential and specialised inputs. there are a few sellers. in the long run. Since under oligopoly. Some may be small. (5) Lack of Uniformity: Another feature of oligopoly market is the lack of uniformity in the size of firms. This is true competition. others have to follow him to keep up their sales. Such a situation is asymmetrical. (c) high capital requirements due to plant costs. (d) exclusive patents and licenses. others very large. a move by one seller immediately affects the rivals. (4) Barriers to Entry of Firms: As there is keen competition in an oligopolistic industry. . on the other hand. However. If. and (e) the existence of unused capacity which makes the industry unattractive. the presence of competition. there are some types of barriers to entry which tend to restraint new firms from entering the industry. Finns differ considerably in size. there are no barriers to entry into or exit from it. the oligopolistic industry can earn long-run super normal profits. This is very common in the American economy. advertising costs.does not match up with them he will find his customers gradually going in for his rival’s product. etc. 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. When entry is restricted or blocked by such natural and artificial barriers.

less or no price reduction by rival sellers. If . This situation is shown in Figure 1 where KD 1 is the elastic demand curve and MD is the less elastic demand curve. Since under oligopoly the exact behaviour pattern of a producer cannot be ascertained with certainty. Presumably. For example. It may still be indefinite and indeterminate. Leaving aside retaliatory price movements. his demand curve cannot be drawn accurately. How does an individual seller s demand curve look like in oligopoly is most uncertain because a seller’s price or output moves lead to unpredictable reactions on price-output policies of his rivals. a number of conjectural demand curves can be imagined. The chain of action reaction as a result of an initial change in price or output. and with definiteness. a demand curve can be drawn by the seller within the range of competitive and monopoly demand curves. then how does he affect his sales. 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. The reason is quite simple. In each case. which may have further repercussions on his price and output. However. more.(6) Demand Curve: It is not easy to trace the demand curve for the product of an oligopolist. the individual seller’s 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. The oligopolies’ demand curve is the dotted kinked KPD. a reduction in price by one seller may lead to an equivalent. If the oligopolist seller does not have a definite demand curve for his product. is all a guess-work. in differentiated oligopoly where each seller fixes a separate price for his product. his sales depend upon his current price and those of his rivals.

when he raises the price of his product. So this individual seller will experience a sharp fall in the demand for his product.a seller reduces the price of his product. 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. they act and react on the price-output movements of one another in a continuous element of uncertainty. All rivals enter into a tacit or formal agreement with . On the other hand. Thus his demand curve above the price P in the segment KP will be highly elastic. the other sellers will not follow him in order to earn larger profits at the old price. Thus the imagined demand curve of an oligopolist has a comer or kink at the current price P. his rivals also lower the prices of their products so that he is not able to increase his sales. Such a demand curve is much more elastic for price increases than for price decreases. Each wants to remain independent and to get the maximum possible profit. So the demand curve for the individual seller’s product will be less elastic just below the present price P (where KD1and MD curves are shown to intersect). (7) No Unique Pattern of Pricing Behaviour: The rivalry arising from interdependence among the oligopolists leads to two conflicting motives. Towards this end.

” 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. the individual seller’s demand curve is a part of the industry demand curve. 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 monopolistic competition refers to competition among a large number of sellers producing close but not perfect substitutes for each other. it is not possible to predict any unique pattern of pricing behaviour in oligopoly markets. though not perfect. 5.regard to price-output changes. among many firms making very similar products. Thus there is no recognised interdependence of the price-output policies of the sellers and each seller pursues an independent course of action. Given these conflicting attitudes. They are “many and small enough” but none controls a major portion of the total output. It leads to a sort of monopoly within oligopoly. “There is competition which is keen. (2) Product Differentiation: . In this case. having the elasticity of the latter. It’s Features: The following are the main features of monopolistic competition: (1) Large Number of Sellers: In monopolistic competition the number of sellers is large. They may even recognise one seller as a leader at whose initiative all the other sellers raise or lower the price. Monopolistic Competition: Monopolistic competition refers to a market situation where there are many firms selling a differentiated product.

Product “differentiation may be based upon certain characteristics of the products itself. It is elastic but not perfectly elastic within a relevant range of prices of which he can sell any amount.One of the most important features of the monopolistic competition is differentiation. such as exclusive patented features. trade names. They are heterogeneous rather than homogeneous so that each firm has an absolute monopoly in the production and sale of a differentiated product. colour. the demand curve (average revenue curve) of a firm under monopolistic competition slopes downward to the right. Product differentiation implies that products are different in some ways from each other. No doubt there is an element of differentiation nevertheless the products are close substitutes. trade-marks. As a result. they can leave or enter the industry or group in the long run. slight difference between one product and other in the same category.” (3) Freedom of Entry and Exit of Firms: Another feature of monopolistic competition is the freedom of entry and exit of firms. an increase in its price will reduce its demand substantially but each of its rivals will attract only a few of its customers. each will lose only a few of its customers. . design. Therefore. (4) Nature of Demand Curve: Under monopolistic competition no single firm controls more than a small portion of the total output of a product. peculiarities of package or container. Products are close substitutes with a high cross-elasticity and not perfect substitutes. As firms are of small size and are capable of producing close substitutes. It may also exist with respect to the conditions surrounding its sales. if any. however. Likewise. 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. There is. or singularity in quality. or style.

(6) Product Groups: There is no any ‘industry’ under monopolistic competition but a ‘group’ of firms producing similar products. free service.(5) Independent Behaviour: In monopolistic competition. etc. free sampling. 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. . cigarettes. selling costs are essential to push up the sales. none controls a major portion of the total output. The monopolistic competitor can change his product either by varying its quality. packing. etc. premium coupons and gifts. or by changing promotional programmes. etc. advertisement. Each firm produces a distinct product and is itself an industry. it includes expenses on salesman. every firm has independent policy. a firm increases sales and profits of his product without a cut in the price. The features of market structures are shown in Table 1. such as cars. (7) Selling Costs: Under monopolistic competition where the product is differentiated. (8) Non-price Competition: Under monopolistic competition. allowances to sellers for window displays. Besides. Chamberlin lumps together firms producing very closely related products and calls them product groups. Since the number of sellers is large.

this article deals with determination of a level of output.com/- dKe2rglfU7c/Ti951vazw2I/AAAAAAAAAA0/uXHTV18g5sU/s1600/marketequilibrium. In order to clearly understand the concept of producer’s equilibrium.jpg Like consumer.bp. So. which yields the maximum profit. a producer also aims to maximise his satisfaction. But a producer’s satisfaction is maximised in terms of profit. .blogspot.28-30…The Producer’s Equilibrium | Microeconomics Read this article to learn about the producer’s equilibrium! Image Curtsey: 2. it is necessary to understand the meaning of profit.

The amount received from the sale of goods is known as ‘revenue’ and the expenditure on production of such goods is termed as ‘cost’. Before we proceed further. “Producer’s Equilibrium by TR-TC approach” is given. . It means. In this situation. Producer can attain the equilibrium level under two different situations: (i) When Price remains Constant (It happens under Perfect Competition). Total Revenue and Total Cost Approach (TR-TC Approach) 2. There are two methods for determination of Producer’s Equilibrium: 1. 3 crores. we must be clear about one more point. then profit will be Rs. Marginal Revenue and Marginal Cost Approach (MR-MC Approach) It must be noted that scope of syllabus is restricted to “Producer’s Equilibrium by MR. any quantity of a commodity can be sold at that particular price. 7 crores. if a firm sells goods for Rs. firm has to accept the same price as determined by the industry. 10 crores after incurring an expenditure of Rs. Producer’s Equilibrium: Equilibrium refers to a state of rest when no change is required. for better understanding. For example. Still.MC Approach”.Meaning of Profit: Profit refers to the excess of receipts from the sale of goods over the expenditure incurred on producing them. The difference between revenue and cost is known as ‘profit’. 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.

i. when difference between TR and TC is the maximum.(ii) When Price Falls with rise in output (It happens under Imperfect Competition). According to TR-TC approach.e. both the conditions are necessary to attain the producer’s equilibrium. But. 10 per unit: . when he maximises the difference between TR and TC.e. it must be supplemented with the second condition. Let us now discuss determination of ‘Producer’s Equilibrium’ by both the methods under the two situations separately. where market price is fixed at Rs. it can increase sales only by reducing the price. So. two essential conditions for producer’s equilibrium are: The difference between TR and TC is positively maximized. For detailed discussion on Perfect and Imperfect Competition. After reaching such a position. producer’s 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. Total profits fall after that level of output. refer Chapter 10. each producer aims to produce that level of output at which he can earn maximum profits. firm follows its own pricing policy. Total Revenue-Total Cost Approach (TR-TC Approach): A firm attains the stage of equilibrium when it maximises its profits.1. The first condition is an essential condition. In this situation. Let us understand this with the help of Table 8. However. Producer’s Equilibrium (When Price remains Constant): When price remains same at all output levels (like in case of perfect competition). So. i. there will be no incentive for the producer to increase or decrease the output and the producer will be said to be at equilibrium.

8 after 4 units of output. In Fig.1. TC s) ) ) ) (Rs.) Remarks 0 10 0 5 -5 Profit rises with 1 10 10 8 2 increase 2 10 20 15 5 in output 3 10 30 21 9 Producer’s 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. the maximum profit of Rs. Total profit falls to Rs. (Rs.Table 8. both the conditions of producer’s equilibrium are satisfied: 1. 9 can be achieved by producing either 3 units or 4 units. the producer will be at equilibrium at 4 units of output because at this level. At this level of output. 2. 8. tangent to TC curve (at point G) is .1.1: Producer’s Equilibrium (When Price remains Constant): Outp Pric Profit ut e TR TC = TR- (unit (Rs. 9. Producer is earning maximum profit of Rs. Producer’s equilibrium will be determined at P OQ level of output at which the vertical distance between TR and TC curves is the greatest. (Rs. But.

) Remarks 0 10 0 2 -2 Profit rises .2: Table 8. such as OQ1 or OQ2 units. i. Producer’s Equilibrium (When Price Falls with rise in output): When price falls with rise in output (like in case of imperfect competition). (Rs. So.e. (Rs. the tangent to TC curve would not be parallel to the TR curve. At quantities smaller or larger than OQ.parallel to TR curve and difference between both the curves (represented by distance GH) is maximum. the producer is at equilibrium at OQ units of output. Let us understand this with the help of Table 8.2: Producer’s Equilibrium (When Price Falls with rise in output): Outp Pric Profit ut e TR TC = TR- (unit (Rs. when difference between TR and TC is the maximum. TC s) ) ) ) (Rs. each producer aims to produce that level of output at which he can earn maximum profits.

tangent to TR curve (at point H) is .2. producer will be at equilibrium at 4 units of output because at this level. Total profits fall to Rs. 10. 5 after 4 units of output. 8. producer’s equilibrium will be determined at OQ level of output at which the vertical distance between TR and TC curves is the greatest. with 1 9 9 5 4 increase 2 8 16 9 7 in output 3 7 21 11 10 Producer’s 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. both the conditions of producer’s equilibrium are satisfied: Producer is earning maximum profit of Rs.2. In Fig. At this level of output.

equilibrium is not achieved when MC < MR as it is possible to add to profits by producing more. MC is greater than MR after MC = MR output level: When MC is greater than MR after equilibrium. it is profitable for the producer to go on producing more because it adds to its profits. Profits will increase as long as MR exceeds MC and profits will fall if MR is less than MC. MC = MR: We know. For this. 2. 2. Both the conditions are needed for Producer’s Equilibrium: 1.parallel to the tangent to TC curve (at point G) and difference between both the curves (represented by distance GH) is maximum. it means producing more will lead to decline in profits. He stops producing more only when MC becomes equal to MR. 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. the firm will be at equilibrium when MC – MR. Every producer aims to maximize the total profits. a firm compares it’s MR with its MC. It means. So. Producer is also not in equilibrium when MC > MR because benefit is less than the cost. Marginal Revenue-Marginal Cost Approach (MR-MC Approach): According to MR-MC approach. MC = MR: As long as MC is less than MR. producer’s equilibrium refers to stage of that output level at which: 1. MC is greater than MR after MC = MR output level: .

So. MC TC s) ) ) ) ) (Rs. but not sufficient enough to ensure equilibrium. Let us understand this with the help of Table 8. only that output level is the equilibrium output when MC becomes greater than MR after the equilibrium. if MC is less than MR beyond MC = MR output. then producing beyond MC = MR output will reduce profits. 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. out of these. first condition must be supplemented with the second condition to attain the producer’s equilibrium. Price or AR remains same at all levels of output.) 1 12 12 13 12 13 -1 2 12 24 25 12 12 -1 3 12 36 34 12 9 2 . 12 per unit: Table 8. AR curve is same as MR curve. it is possible to add to profits by producing more. However. (Rs.) (Rs.3. It is because if MC is greater than MR. firms can sell any quantity of output at the price fixed by the market. where market price is fixed at Rs. It is because MC = MR may occur at more than one level of output. On the other hand.3: Producer’s Equilibrium (When Price remains Constant) Outp Pric Profit ut e TR TC MR = TR- (unit (Rs. Producer’s Equilibrium (When Price remains Constant): When price remains constant. Also. (Rs.MC = MR is a necessary condition. the revenue from every additional unit (MR) is equal to AR. (Rs. It means.

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. Let us now discuss determination of equilibrium with the help of a diagram: Producer’s Equilibrium is determined at OQ level of output corresponding to point K as at this point: (i) MC = MR. Producer’s Equilibrium will be achieved at 5 units of output. MC = MR condition is satisfied at both the output levels of 2 units and 5 units. Both AR and MR curves are straight line parallel to the X-axis. and (ii) MC is greater than MR after MC = MR output level. Producer’s equilibrium will be determined at OQ level of output corresponding to point K because only at point K. But the second condition. MC curve is U- shaped.3. Therefore. and 2.3. MC = MR. output is shown on the X-axis and revenue and costs on the Y-axis. the following two conditions are met: 1. 8. MC is greater than MR after MC = MR output level . In Fig. ‘MC becomes greater than MR’ is satisfied only at 5 units of output.

4: Table 8. MR curve slope downwards. but it is not the point of equilibrium as it satisfies only the first condition (i. it means. the producer will be at equilibrium at point K when both the conditions are satisfied. MC TC s) ) ) ) ) (Rs. Let us understand this with the help of Table 8. Producer’s Equilibrium (When Price Falls with rise in output): When there is no fixed price and price falls with rise in output. (Rs. So. As equilibrium is achieved when MC = MR.e. then Price (or AR) = MR. “Gross Profits are Maximum at Point of Producer’s Equilibrium”. MC = MR).Although MC = MR is also satisfied at point R. refer Power Booster Section.) (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 .4: Producer’s Equilibrium (When Price Falls with rise in output): Outp Pric Profit ut e TR TC MR = TR- (unit (Rs. (Rs.5 0 5 4 20 26 0 6 -6 . Producer aims to produce that level of output at which MC is equal to MR and MC curve cuts the MR curve from below. For. price is equal to MC at the equilibrium level. Relation between Price and MC at Equilibrium (When Price remains Constant): When price remains same at all levels of output.

According to Table 8.4. and 2. output is shown on the X-axis and revenue and costs on the Y-axis.4. Let us understand the determination of equilibrium with the help of a diagram: Producer’s Equilibrium is determined at OM level of output corresponding to point E as at this point: (i) MC = MR. MC is greater than MR after MC = MR output level. Relation between Price and MC at Equilibrium (When Price Falls with rise in output): . MC = MR. Producer’s Equilibrium will be achieved at 3 units of output. and (ii) MC is greater than MR after MC = MR output level. So. 8. the following two conditions are met: 1. MC is equal to MR and MC is greater than MR when more output is produced after 3 units of output. So. Producer’s equilibrium will be determined at OM level of output corresponding to point E because at this. both the conditions of equilibrium are satisfied at 3 units of output. the producer is at equilibrium at OM units of output. In Fig.

Besides the two conditions of pure competition mentioned above several other conditions must be fulfilled to make it a perfect competition. Thus the commodity produced by different firms are perfect substitutes. Homogenous product: The commodity produced by all firms should be identical in pure competition. If the demand exceeds supply additional factors of production move into the industry and vice versa. it means. Free mobility of the resources: The mobility of resources is essential to the firms in order to adjust their supply to demand.  Video Games Price and output determination under perfect competition: Meaning of perfect competition Perfect competition is wider concept than pure competition. Perfect competition is wider term than pure competition. price is more than MC at the equilibrium level. Perfect knowledge: Another assumption of perfect competition is that the purchasers and sellers should have perfect knowledge about costs. If it is so. When more output can be sold only by reducing the prices. then Price (or AR) > MR. new firms will enter and extra profit will be reduced and if the profit is less than normal. 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. 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. Due to this fact neither the seller can charge more than the ruling price nor the purchaser are willing to pay more. some firms will leave the industry raising the profits for the remaining firms. Free entry and exit: There should be no restrictions legal or other on the firms to entry and exit the industry. Hence the buyers are indifferent as to the firm from which they purchase. the output of any single firm is only a small proportion of the total output and each consumer buys small part of the total. Because if the profit is more than the normal. price and quality. In this situation all the firms can earn only normal profit. Price Determination . Hence the firms can earn normal profit in long run. As equilibrium is achieved when MC = MR.

So the problem is to determine the output level to maximize profit. the equilibrium price is determined at the point where quantity demanded and quantity supplied are equal. Hence average variable cost plays an important role in making decision whether to produce or not. When price is Rs 5 per unit. Similarly at price Rs 4 quantity demanded 10 units is less than the quantity supplied 16 units causes to fall in price. quantity demanded and quantity supplied are equal at 12 unit.e. Short run equilibrium of the firm and industry: Under perfect competition a firm takes price as given. Hence price remains constant in perfect competition. Similarly at price less than OP demand is greater than supply causes to rise in the price. In the other words.Before Marshall there was controversy among economists on whether the force of demand (i. If . DD is the demand curve and SS is the supply curve. at this price the buyers who are willing to buy will find that quantity offered is not sufficient to satisfy their wants. buyer’s and seller’s desire are inconsistent.” As we know that quantity demanded and quantity supplied vary with price . 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. According to him. marginal utility ) or the force of supply (i. 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. Marshall gave equal importance to both the demand and supply in determination of price. so is both demand and supply essential for determination of price.e. It is seen in the table that when price is Rs 3 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. In other words in perfect competition single firm and consumer cannot influence the price by varying their supply and demand respectively. Similarly at price Rs 1 quantity demanded 20 is greater than quantity supplied zero causes to increase in price. the price has been measured along vertical axis and quantity along horizontal axis. So OP is the equilibrium price. The process of price determination can be explained with the help of following diagram: In the figure above. cost of production) is more important is determining price. At price more than OP supply is greater than demand causes to fall in the price. 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. If the equality between quantity demanded and quantity supplied doesn’t hold for some price. It is seen in the figure that at price OP quantity demanded is equal to the quantity supplied. Hence the equilibrium price OP is determined by demand and supply both. 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. “As both blades of a scissors are important for cutting a cloth.

And the total cost for producing OM amount of output is represented by rectangle DOMC (average cost OD x quantity OM). 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). The total revenue earned by the firm by producing OM amount of output is represented by rectangle AOMB (price OA x quantity OM). For example. Hence profit maximizing level of output is OM and long run equilibrium of the firm under perfect competition is at point F. Long run equilibrium of the firm and industry: In long run no firm can make abnormal profit or losses under perfect competition.the price falls below the minimum average variable cost then the firm will shut down in order to minimize losses. If the equilibrium point lies below to the AC curve then the firm will be in losses. MC and MR are equal and MC cuts MR from below. So the minimum variable cost sets a limit to the price in short run. At point F. 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 the firm produces OM amount of commodity and sales at OP price. 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 the firm earns abnormal profit represented by the shaded rectangle ABCD( total revenue AOMB – total cost DOMC). Note: If AC is tangent at equilibrium point then firm earns normal profit. where the conditions of profit maximization are fulfilled. As shown in the figure at OM level of output both conditions of profit maximization or equilibrium of the firm are fulfilled. This is because abnormal profit will attract new firms into the industry. So the firm earns normal profit only. If the equilibrium point lies above to the AC curve then the firm earns abnormal profit. Hence at OP price the firm can sale any amount of output. new firms are not encouraged to enter nor existing firms are pressured to leave the industry. 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. Hence at OP price the firm can sell any amount of output. So the industry as a whole will be in equilibrium. When this condition exists for all firms in the industry. Price and output determination under monopoly: . As we know that in long run no firm can make abnormal profit. As we know that firm will be in equilibrium when it is earning maximum profit. The short run equilibrium of the firm requires short run equality between demand and supply. Hence the supply of commodity increases leads to fall in the price and abnormal profit will disappear. it is seen in the figure that at point F. MC=MR=AR=P. Similarly if there is losses some firms will leave the industry .

Long run equilibrium: There is no entry of new firms even in long run under monopoly. MR is the marginal revenue curve lying below the AR. the firm earns abnormal profit represented by the rectangle ABTP. AR is the demand curve or average revenue curve facing monopolist. Absence of close substitutes : There should not exist any close substitute of the commodity. Therefore the monopolist will be in equilibrium at OM level of output and the profit is the maximum. 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.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. At the price OP and output level OM. 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. The following conditions are necessary for pure monopoly: Single seller : There should be only one seller or producer of a single commodity. 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. Since the average revenue curve is not horizontal straight line. . H. The price OP is determined by the equilibrium level of output OQ. competition prevails and monopoly disappears. As we know that the equilibrium condition requires that MC curve must cut MR curve from below. 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. At OM level of output the monopolist earns abnormal profit represented by the rectangle ABTP. MR curve will not coincide with AR. Until OM level of output. Hence the existing firm has control over the supply of the product. 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. Price and output determination under monopolistic competition E. SAC and SMC are the average cost and marginal cost curves. In other words it is the region of imperfect competition laying between these extreme limit. Restriction on the entry of new firms : There should be restrictions on the entry of new firms. Imperfect competition covers all situations where there is neither pure competition nor pure monopoly. So abnormal profit is maintained even in long run. Hence the average revenue curve under monopoly slopes downward. If there are substitutes. Since there is only one firm under monopoly so the distinction between the firm and industry disappears under the conditions of monopoly. In other words under monopoly the marginal revenue curve lies below the average revenue. Chamberlin has developed this in 1933 because perfect competition and monopoly are imaginary but monopolistic competition is real. MR is greater than MC but beyond OM the marginal revenue is less than the marginal cost. Monopoly may be in the form sole proprietorship or joint stock company.

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 . AR curve slopes downward indicates more will be demanded at lower cost. the output of any single firm is only a small proportion of the total output and each consumer buys small part of the total. So in perfect competition the product differentiation is zero elasticity of demand is perfectly elastic. 3 Non price competition Price is determined by the entrepreneur himself. colgate etc (different in some quality .The average revenue curve slopes downward throughout it’s length but slopes downward at different rate in different categories of imperfect competition. Features of monopolistic competition 1 Product differentiation Goods are not homogeneous but similar and close substitute like different brands of toothpaste closeup pepsodent. 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. 4 goal of firm is to maximized profit 5 The price of factors of production is given. 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. color. The higher the production differentiation lower will be elasticity and lower the production differentiation higher will be elasticity. Long run equilibrium AT equilibrium. In other words downward slope indicates more can be sold by lowering the price because consumer of other product will be attracted. size or covering). 7 free entry and exit of the firm. In case of nearly perfect competition AR slopes gently downward and it slopes steeply where competition is strictly imperfect. 6 Equilibrium of the firm does not occur at the lowest point of AC but left to lowest point. Short run equilibrium: The cost curves are u shaped indicates only one level of output can be produced at lowest cost. If it is so.

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. 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 industry. So in monopoly output is lower and price will be higher than perfect competition. Firms earn normal profit Firms earn normal profit . 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.

close substitute like close up and colgate toothpaste. Large numbers of sellers and buyers Product homogeneous means good are Product differentiation means goods are perfect substitute. and science across vast geographic areas. Chapter 7. information. Large numbers of sellers and buyers. 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. 7. Globalization and the traditional role of agriculture [124] A Social Experiment Domestic Abuse Almost Went Wrong! | BuzzWok. inputs. output. . 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. there is an implication of frictionless movement and perfect knowledge that understates the requirements for benefiting from globalization. However.com | 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”.1 Introduction Globalization refers to increases in the movement of finance.

They become poorer and more food insecure. Concurrently. non-tradable rural non-farm sector. increases in per capita income in many regions. complex relations between low- . which increasingly depends on constantly advancing basic research. Thus. With such potential benefits. and prices decline. 7. and consequently lower costs and rapid growth in trade. All too many of the least-developed countries fall into this category.These trends have been underway throughout history. Nowhere is this more dramatic than in Africa. It also increases the potential for agriculture to increase food security through enlarged multipliers to the massive. These rapid changes have allowed a great increase in specialization in agriculture. Private firms are responsible for a much larger absolute and relative share of agricultural research than in the past. and the pace is accelerating. while perishability and bulk have been drastically reduced.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. which has suffered from increasingly efficient production of first oil palm. most of which involve value added processes that themselves require investment and improved technology. 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. eventually reverting to minimum subsistence agriculture. Benefiting from research is now far more complex than a few decades ago. 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. Basic research is moving far faster than ever before. 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. and now coffee from Asian countries that have been spending on research. have allowed scale economies to be achieved for myriad new products. incomes of the non-innovators will decline. lower prices are often rapidly transmitted to producers who have not participated in cost reduction. 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. then cocoa. and in the total size of the market. To benefit from modern biological science. partly due to the forces of globalization. they will experience a decline in income. If they have not experienced cost reduction in other endeavours either. As reflected in the previous chapter. Cost reduction largely derives from technological advance Cost-reducing technological change is the product of applied research. constantly changing the context for applied research. employment-intensive. Real costs of information transfer and shipment of goods have declined rapidly.

Now it is 4 to 6 percent . imports. Thus. Rural roads in low-wage. 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. Such costs are reduced by investment in physical infrastructure . The bulk of growth initially came from basic food staples when the scope for export markets is limited. private sector research and high- income countries. Hence foreign sources of competition may face low transport costs while domestic producers in low-income countries may face high transport costs. Agricultural production in these countries takes place in rural areas that are frequently deficit in physical infrastructure.3 The commodity composition of agriculture Globalization has allowed agricultural production to grow much faster than in the past. 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.income and high-income countries must be developed and even more complex relations between private sector and public sector research. [126] .most notably roads. However. As exports of high-value agricultural commodities increase and the multipliers to per capita income develop. However. A few decades ago fast growth was somewhat over 3 percent per year. Well operating markets in low-income countries are concentrated in major cities with reasonably good physical infrastructure and hence at least moderate transaction costs. whereas there is now a swing towards much higher value commodities. the protectionist measures of the past are being allowed to continue in high-income countries. High quality coffee and tea are examples. Globalization has greatly increased the returns to roads and consequently radical to reductions in costs. domestic demand for high-value livestock and horticulture will increase rapidly . the WTO works to reduce trade barriers and to enforce agreed rules. posing the threat of increased competition to local production. often subsidized. For low-income countries. Undertaking international trade is constantly decreasing in cost. The first requisite for benefiting from research externalities is a strong national research system. However. WTO rules constrain the extent to which countries can protect themselves Created to facilitate the processes of globalization. [125] these higher rates of growth involve a substantial change in its composition. improved infrastructure also facilitates the movement of imported goods further into the rural economy. 7. Explosive growth in income of high-income countries means that large aggregates of production can now occur in what were previously small niche markets. particularly Africa. Rate of return analysis shows that all low-income countries are vastly under-investing in applied agricultural research. Thus major urban markets in low-income countries are increasingly open to foreign competition. but also communications. whilst many low-income countries are opening their borders to. The market for horticulture exports has also grown immensely and can continue to grow.

As a result. The same is true for investments in all the value-added enterprises. They include many with a small tract of land that is insufficient to provide minimum subsistence.e. Much of such activity is through capital-intensive processes. 7. Second. even while they lose from declining prices of other agricultural commodities. The marginal propensity of the poor to spend on food is high. As the production mix moves more towards export crops and high-value crops and livestock. the role of cereal production will become relatively less important. [128] The great majority of persons below the poverty line work in the rural non-farm sector. The supply of rural non-tradables is highly elastic. 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. The primary means by which low-income people increase their incomes and hence their food security is through increased employment.4 Converting the benefits of globalization into food security A major element in ensuring food security is increased incomes of poor people. that is they are dependent on local sources of demand. First. The cost of shipping is declining. 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. Both will give comparative advantage to high-income countries. any shift of income distribution towards the low-income. The agricultural demand shows strong growth multipliers since the rural non-farm sector also tends to spend substantially on itself. The rural non- farm sector uses very little capital and hence is highly employment-intensive. It is agricultural growth that reduces poverty . Cereals play an important role in food security in a global economy. 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. It produces goods and services that are dominantly non-tradable. double cropping) or extensification are not possible. mainly because labour is the primary input and labour is elastic in supply as long as incomes are low . around half the increments to agricultural production will be in high value horticulture and livestock for both export and domestic use. This sector is highly elastic in supply. Agricultural growth is the underlying source of that demand growth. low-income countries may be beneficiaries of declining cereal prices. the rate of return to investments that reduce transaction costs will increase rapidly. Two forces in developing countries may lead to increased cereal imports. Thus. will shift the demand schedule upwards. food insecure.even in quite low-income countries. There are also complexities in marketing. and agriculture’s impact is dependent on growth rates [127] that are considerably higher than population growth rates. as would be expected of a labour-intensive sector in a low-wage economy. There is however a caveat on value added. The latter are indirect. food insecure .

It is demand that constrains growth of the sector [129] and that demand comes from high agricultural growth rates. no amount of opening of markets will help. Identifying supporting mechanisms such as research and training to minimise the exclusion of small resource poor farmers from value chains is also important. agriculture must grow substantially faster than population growth. Without such investment. Customs inefficiencies and corruption and a myriad other bureaucratic constraints are just as stifling as tariffs and all need to be dealt with. Opening the economy to trade and market forces The benefits of globalization flow from trade. Below. 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. Investing in agricultural research and dissemination Low-income countries need to invest far more than at present in agricultural research and technology dissemination. but trade restrictions tend to drive up the cost of exports through higher costs of vital inputs and technology. opening to global market forces does little good if costs are not being constantly reduced. However. This will include the traditional bulk exports such as cotton. 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. Investing in rural infrastructure Given the deplorable state of rural infrastructure in low-income countries. irrigation. tea. storage are . if the result of global forces interacting with domestic investment and policy is to leave comparative advantage with subsistence production.or underemployment is endemic. Put differently. massive investments are needed Investment in other economic risk reduction services such as insurance. 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. Without these a nation cannot compete: it is no accident that it is African nations that suffer the most from declining commodity prices. coffee. not just for the final product. then major components of agriculture must be exported. opening markets will do little good for agriculture and hence for poverty reduction and food security. oil palm. Comparative advantage needs to be seen for each component of a supply chain. For a major effect on employment. the urgent requirements for low-income countries to benefit from globalization are presented. and non-traditional exports including horticulture. If it is to grow at the 4 to 6 percent rates required for achieving employment levels essential to food security. Exports require imports.usually associated with absentee landlords who have quite different consumption patterns from those of peasant farmers.

although it is a necessary condition. Delinking payments to farmers from prices is not sufficient. They must also ensure that farm income transfers do not depress world prices. Reduced livestock prices are a particularly onerous burden on farmers of low-income countries with little mitigating benefit. as well as bringing private sector research to low-income countries and engendering cooperation. 7. 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. Such efforts need to facilitate private sector action and gradually low-income countries need to play that role themselves. 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. In the case of most low-income countries.also likely to be required. developing and enforcing grades and standards. 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. particularly in trade. Private sector investors in low-income countries tend to search for quick turnover. rather than relying on foreign aid. in a sense acting as public sector.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. particularly for high- value crops. would also help meet environmental objectives. meeting health regulations of high-income importers. High-income countries must also open their markets to low-income countries. The Doha Round should be used to obtain agreement from high-income countries to reduce support payments to farmers.” However. This might roll back some of the recent excesses. Payments to farmers keep resources producing that would otherwise be withdrawn serve to depress prices. improved infrastructure also lowers the final cost of imports in the producing areas. They should work with low-income countries in meeting phytosanitary rules and other obstacles to trade. especially in exports. It is not enough to remove bureaucratic constraints. Initially. . 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. Lower cotton prices are a disaster for low-income cotton producers and lower vegetable oil prices are similarly a strong negative factor. Withdrawing land from production as part of payments and making payments that encourage lower yields per hectare and per animal. Winters notes that “the transaction costs of trade with remote villages are often so great that it can [130] be cheaper for grain mills to buy from distant commercial growers than from small farmers located in the region. 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. such efforts are sometimes financed by foreign aid programs. diagnosing special niche markets and carrying out analysis of constraints.

in the sense of rapid transmission of the impact of technology to all areas of the globe with highly developed infrastructure. It follows that a massive food-aid programme in the context of rural infrastructure development would be an important contribution of high-income countries. must redirect public expenditure to agricultural production. High-income countries should provide financial support for a massive programme of rural public works. Thus. Thus. High-income countries can assist this process though continuing to open trade in agricultural commodities. especially research and rural infrastructure. demand for basic food staples would expand 9 percent more than supply.While production-increasing policies for cereals hurt some countries. will continue to accelerate. 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. including over valued exchange rates. increasing employment. but without offsetting decreases in costs of production. and as explained below could be used in the context of building rural public works. In contrast. so lower prices are helpful to them. because of quality and transaction costs. a massive rural public works programme would require imports of cereals roughly equal to 9 percent of domestic basic food staples production. and consider cutting customs barriers.6 Conclusion Globalization. Low-income countries are increasingly importers of cereals. That would have powerful multipliers to the rural non-farm sector. where costs are reduced by research and improved infrastructure. That would bring about a roughly 30 percent increase in domestic prices of basic food staples. This would be a disaster for poor people. 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. cereals are a special case. These people are almost always net purchasers of cereals. preventing domestic farm support programmes from dumping commodities on world markets. in the case of cereals. and increasing food security. This chapter is based on a paper by John Mellor. They should reduce constraints to trade. 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. and. Low-income countries. which are largely non-tradable in Rwanda. they in general benefit the food insecure. agriculture can attain growth rates of at least 50 percent higher than in the past. particularly in the context of their domestic farm-support programmes. 7. The Impacts of Globalisation on the Role of [124] Agriculture presented at the Expert Consultation on Trade and Food Security: Conceptualizing the . especially in Africa. and will be more so as the area devoted to high-value commodities is expanded. Such a programme on an Africa-wide basis would absorb the bulk of excess production of cereals in the high-income countries. thereby reducing poverty.

C. agriculture. [128] Mellor. 1996. vol. DC. J. A. & Ranade. December. Agriculture on the Road to Industrialization. J. 1. 11-12 July 2002. Abt Associates. [126] Mellor. C. Brighton: University of Sussex. 2002..1. 1988. ×Ads by OffersWizard Ads by OffersWizardAd Options ×Ads by OffersWizard You May Like X You should check this out Glispa . 1997. op cit. 61-74 [130] Winters. Rome. and urban tradables.P. W. 2000. [125] Mellor. Baltimore. & Datt. 2002. Johns Hopkins University Press. Bethesda. 178. World Development. no. no. Bethesda. Mimeo. W. Productivity increasing rural public works . non-tradables. G. M.Linkages. Abt Associates. 2002. Mellor. How Important to India’s poor is the sectoral composition of economic growth. Vol. and Liedholm. Bethesda. L. 1992. Abt Associates. Mead. Harvard Institute for International Development. Modeling Egyptian employment with a three sector model. J. Cambridge. pp. 2001. 26. W. Trade liberalisation and poverty. J. The dynamics of micro and small enterprises in developing countries. The World Bank Economic Review.an interim approach to poverty reduction in Rwanda. C. A study of SME’s in Rural Egypt published by Abt Associates. How well do the poor connect to the growth process? CAER Discussion Paper No. Inc. 1992. J.10. Rapid Employment Growth and Poverty Reduction: Sectoral Policies in Rwanda. Bethesda. [129] EQI. Mellor. Timmer. [127] Ravallion.

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